M5 Financial Risk Management: Part 1 Flashcards
Definitions: the chance of financial loss “uncertainty”
Risk
Definitions: the total gain or loss experienced on behalf of the owner of an asset over a given period
Return (typically greater risks yields greater returns)
Risk preferences definitions: reflects an attitude toward risk in which an increase in the level of risk does not result in an increase in management’s required rate of return
Risk-Indifferent behavior
Risk preferences definitions: reflects an attitude toward risk in which an increase in the level of risk results in an increase in managements required rate of return
Risk-Averse (general rule)
Risk preferences definitions: reflects an attitude toward risk in which an increase in the level of risk results in a decrease in management’s required rate of return
Risk-Seeking behavior
Types of Risk: fluctuations in the value of the instrument in response to changes in interest rates
Interest Rate Risk (or Yield Risk); as IR UP, value of fixed income DOWN
Types of Risk: fluctuations in value as a result of operating within an economy; nondiversifiable risk (war, inflation, political events)
Market/systematic/nondiversifiable risk
Types of Risk: portion of a firm’s or industry’s risk that is associated with random causes and can be eliminated through diversification
Diversifiable risk/unsystematic/firm-specific
2 Broad categories of risk (DUNS)
D Diversifiable Risk
U Unsystematic Risk (nonmarket/firm-specific)
N Nondiversifiable risk
S Systematic risk (market)
Types of Risk: affects borrowers; includes a company’s inability to secure financing or secure favorable credit terms as a result of poor credit ratings
Credit Risk
Types of Risk: affects lenders; exposed to the extent that its debtors may not repay the principal or interest due on their indebtedness on a timely basis
Default Risk
Types of Risk: affects lenders (investors); are exposed when they desire to sell their security but cannot do so in a timely manner or when material price concessions have to made to do so
Liquidity Risk
Types of Risk: represents the exposure that investors have to a decline in the value of their individual securities or portfolios
Price Risk
Computation of Return: nominal interest rate that represents the rate of interest charged before any adjustment for compounding or market factors
Computation: rate shown in the agreement of indebtedness
Stated Interest Rate (NO MATH) (SAR- annual)
Computation of Return: represents the actual finance charges associated with a borrowing after reducing loan proceeds for charges and fees related to a loan origination
What is the computation?
Effective Interest Rate
Computation: Divide amount of interest paid based on loan agreement by the net proceeds received
**IF YOU DON’T HAVE ANNUAL RATE = Interest Paid per period (P * Periodic Rate) –> SAR/#periods
DIVIDED by net proceeds (P less loan origination fees less documentary stamp charge, etc.)
Computation of Return: represents a noncompounded version of the effective annual % rate
Computation?
Annual Percentage Rate (APR)
Effective periodic rate * # periods in a year
Computation of Return: represents the stated interest rate (SAR) adjusted for the number of compounding periods per year
Computation?
Effective Annual Percentage Rate (APR)
(1 + effective period rate) ^ # periods - 1
also [1+i/p]^p - 1
i = stated interest rate
p = Compounding periods per year
Computation of Return: amount represented by interest paid only on the original amount of principal without regard to compounding
Computation?
Simple Interest (total interest over life of loan)
PSAR# of years
Also, P(i)(n)
Computation of Return: amount represented by interest earnings or expense that is based on the original principal plus any unpaid interest earnings or expense
Computation?
Compound Interest
P * (1 + Effective periodic)^Total #periods
-effective is expressed as a decimal
OR
Future Value = P (1+i)^n
Required rate of return calculation
Risk-Free Rate + maturity risk premium (MRP) + purchasing power risk/inflation premium (IP) + Liquidity risk premium (LP) + Default risk premium (DP)
Mitigating Risks: Ways to mitigate Diversifiable risk
Diversification (building a portfolio of investments of different and offsetting risks)
Mitigating Risks: Ways to mitigate interest rate risk
-Investing in floating rate debt securities
-Derivatives (i.e. forward rate agreements or interest rate swaps)
Mitigating Risks: Ways to Mitigate Market Risk
-NONDIVERSIFIABLE so not as easy to mitigate
-Invest in derivatives that provide gains to the investor when the market declines
-Short Selling
Mitigating Risks: Ways to Mitigate Unsystematic Risk
Diversification
Mitigating Risks: Ways to Mitigate Liquidity Risk
Allocating a greater percentage of capital to investments that trade on active markets, such as equities, corporate bonds, futures contracts, and options
An option to sell a specific security at fixed conditions of price and time
Put option
An option to buy a specific security at fixed conditions of price and time
Call option
The risk associated with the unique circumstance of a particular company as they might affect the shareholder value of that company
Business risk (inherent if a firm only utilizes equity financing)
The point at which the investor is indifferent to risk
Certainty Equivalent
Interpretation: If certainty equivalent > expect return on an investment, the investor is actually seeking lower return for higher risk (Risk Seeking behavior)
Nominal amount computation
Example question: Company has capital project w. before-tax cash inflows in real dollars that are expected to be 200,000 within 2 years. The inflation rate is expected to be 6% each year during that period. What is the before-tax cash inflow expressed in nominal dollars?
Amount expected * 1.xx * 1.xx (where xx is the inflation rate and over a two year period)
200,0001.061.06 = 224,720
Risk Premium: compensation that investors demand for exposure to interest rate risk over time
Maturity Risk Premium (MRP)
*risk increases with term to maturity
Risk Premium: compensation investors require to bear the risk that price levels will change and affect assess values or the purchasing power of invested dollars
Purchasing power risk or inflation premium (IP)
*used to calculate the nominal RF
Risk Premium: additional compensation demanded by lenders for the risk that an investment security cannot be sold on short notice without making significant price concessions
Liquidity risk premium (LP)
Risk Premium: additional comp demanded by lenders for bearing the risk that the issuer of the security will fail to pay interest and/or principal due on a timely basis
Default Risk Premium (DRP)