M4-Financial Risk Management: Part 1 Flashcards
________ behavior describes managers who demand more return on an investment as risk increases. These managers expect to be compensated for increased risk.
Risk Averse
_________ behavior describes a manager who is neutral with regard to the return associated with a particular investment. Typically, the amount of a risk free rate of return associated with an investment of a given amount compared to a higher return associated with higher risk is viewed as having equal value.
Risk Indifferent
_______behavior describes managers who seek reduced return for higher risk.
Risk Seeking
If an investor’s certainty equivalent, the point at which the investor is indifferent to risk, exceeds the expected return on an investment, then the investor is actually seeking lower return for higher risk.
Portfolio theory is concerned with construction of an investment portfolio that efficiently balances its risk with its rate of return. Risk is often reduced by diversification, the process of mixing investments of different or offsetting risks. The broad categories of risk are summarized in the following mnemonic to get us DUNS>
D Diversifiable
U Unsystematic (non-market/firm-specific)
N Non-diversifiable
S Systematic (market)
Non-diversifiable risk cannot be eliminated by the application of portfolio theory. Non-diversifiable risk is also referred to as market or systematic risk.
Diversifiable risk can be eliminated through effective application or portfolio theory. Diversifiable risks are also termed as:
- non market risk
- unsystematic risk
- firm-specific risk
_______ risk is associated with the ability to sell the temporary investment in a short period of time without significant price concessions.
Liquidity Risk
Financial risk is a general category of risk that includes:
- Interest rate risk
- Market risk
- Purchasing power risk
- Liquidity risk
- Default riks
_______risk is the fluctuation in the value of a “financial asset” when interest rate changes.
Interest rate risk
_______risk is the risk that price levels will change and affect asset values (mostly real estate)
Purchasing Power Risk
The risk of labor strikes can be mitigated by diversification. Diversifiable risk, sometimes called unsystematic or firm specific risk can be mitigated by allocation of a portfolio of investment amongst various firms. (true or fales)
true
Splitting a portfolio between investments in finance companies, which are less prone to strikes, vs. auto manufactures, which have a higher percentage of organized labor, is an example of diversification to mitigate the risk of strikes.
Business risk represents the risk associated with the unique circumstances of a particular company, as they might affect the shareholder value of that company. If an entity purely uses its own cumulative earnings in capitalizing its operations, it is exposed to the risks of its own unique circumstances. (true or false)
true
A derivative is a financial contract which derives its value from the performance of another asset or financial contract (interest rate, stock, asset, etc.) (true or false)
true
A put option gives its owner the right to sell a specific security at fixed conditions of price and time. (true or false)
true
An option to buy is called a call option. A call option gives its owner the right to purchase a specific security at fixed conditions of price and time. (true or false)
true
An interest rate swap agreement would be effective in hedging the risk associated with interest rate fluctuations. A swap agreement is a private agreement between two parties, generally assisted by an intermediary, to exchange future cash payments. (true or false)
true
Ex: In this case, the company would most likely enter into an interest rate swap in which it would pay another party a fixed rate of interest in exchange for receipt of payments of a floating rate of interest. The company would then use the floating interest payments received to pay the interest on its floating-rate bonds. In this way, the company would use the swap agreement to convert its interest payments from floating-rate to fixed rate.
Short-term financing options result in lower interest rates but higher interest rate risks because rates will fluctuate more dramatically for short-term issues than long-term issues. On the other hand, with long-term financing, credit risk will decrease because the company will seek refinancing less frequently and thereby have less credit risk or opportunity that the rates associated with debt will be changed unfavorably or that financing will be denied altogether. (true or false)
true
