FRM Flashcards
AICPA BAR
Define risk and return
Return is income received on an investment plus any change in the market price.
R = [Dt+1 + (Pt+1 – Pt)] / Pt
i.e.: Return = (income of investment + capital gain) / cost of investment
Risk is the variability of returns form those that are expected
Variation = uncertainty = fluctuation
Stated Interest Rate
The rate of interest charged before any adjustment for compounding or market factors. The stated interest rate is the rate shown in the agreement of indebtedness.
Effective Interest Rate
Dividing the amount of interest paid based on the loan agreement by the net proceeds received.
Annual Percentage Rate
Effective Periodic Interest Rate* # of periods in year, the rate required for disclosure by federal regulations
Effective Annual Percentage Rate (APR)
The stated interest rate adjusted for the number of compounding periods per year.
effective rate = [1+(i/N)]^N - 1
Simple interest vs. Compound interest
Simple interest = P * i * N
Compound interest = P * [(1+i)^N - 1]
Types of Risk
Interest Rate Risk (or Yield Risk) : The exposure of the instrument owner to fluctuations in the value of the instrument in response to changes in interest rates.
Market risk: The exposure of a security or firm to fluctuations in value as a result of operating within an economy. It is a risk inherent in operating within the economy. Market risk is a non-diversifiable risk
Systematic risk (market) — > Non-diversifiable risk
Unsystematic risk (nonmarket/firm-specific) — > Diversifiable risk
Credit Risk: a company’s inability to secure financing or secure favorable credit terms as a result of poor credit ratings. As credit ratings decline, the interest rate demanded by lenders increases, collateral may be required, and other terms are generally less favorable to the borrower.
Default Risk: the possible that debtors may not repay the principal or interest due on their indebtedness on a timely basis.
Liquidity risk: The exposure of lenders or investors when they desire to sell their security, but cannot do so in a timely manner or when material price concessions have to be made to do so.
Price Risk: the exposure that the value of securities or portfolios decline with increased market volatility. Price risk is related to diversifiable (unsystematic) risk.
Risk Mitigation
- Mitigating Interest Rate Risk
Leverage Derivatives for hedge, such as forward rate agreements (FRAs) or interest rate swaps, in which the investor pays a fixed interest rate and receives a floating interest rate
2.Mitigating Market Risk
Market risk cannot be mitigated through diversification. Two ways for Market Risk Mitigation
Invest in derivatives that provide gains to the investor when the market declines.
Short selling: selling an investment in the hopes of buying it back at a lower price later
- Mitigating Unsystematic Risk
Risk can be minimized through diversification by holding a broad portfolio of investments. The change of risk in correlated or inversely correlated assets offset each other. - Mitigating Credit Risk
Improvements in credit ratings at entity and individual debt levels, such as optimize capital structure, improve liquidity and profitability etc. - Mitigating Default Risk from lender’s perspective
Choose to lend only to borrowers with low risk of default.
Adjust the interest rates charged to better reflect the risk of each borrower, such that higher-risk borrowers will pay higher interest rates. - Mitigating Liquidity Risk
Allocating a greater percentage of capital to investments that trade on active markets, such as equities, corporate bonds, futures contracts, and options. - Mitigating Price Risk: Diversification, short selling, or derivatives, such as put options.
FX Risk Exposure Categories
Transaction Exposure
An organization could suffer economic loss or experience economic gain upon settlement of individual transactions as a result of changes in the exchange rates.
Economic Exposure
The potential that the present value of an organization’s cash flows could increase or decrease as a result of changes in the exchange rates.
Translation Exposure
The risk that assets, liabilities, equity, or income of a consolidated organization that includes foreign subsidiaries will change as a result of changes in exchange rates.
required rate of return
Minimum return require for investments.
Required rate of return = risk-free rate + inflation premium + maturity risk premium + liquidity risk premium + default risk premium
Circumstances that impact exchange rate
Trade-related factors
Financial factors
what is trade-related factors impacting FX rate
relative inflation rates
relative income levels
government controls
what is financial factors impacting FX rate
relative interest rate
capital flow
FX risk exposure
transaction exposure
economic exposure
translation exposure
managing transaction exposure
- To identify the expected net positions in each foreign currency during several upcoming periods
- to hedge net payables denominated in foreign currency
- futures or forwards
- money market hedge (deposit fx to earn int)
- call option - to hedge net receivable denominated in foreign currency
- futures or forwards
- money market hedge (borrow money)
- put option
