M5 Financial Risk Management: Part 1

Question 1

Definitions: the chance of financial loss “uncertainty”

Answer 1

Risk

Question 2

Definitions: the total gain or loss experienced on behalf of the owner of an asset over a given period

Answer 2

Return (typically greater risks yields greater returns)

Question 3

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

Answer 3

Risk-Indifferent behavior

Question 4

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

Answer 4

Risk-Averse (general rule)

Question 5

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

Answer 5

Risk-Seeking behavior

Question 6

Types of Risk: fluctuations in the value of the instrument in response to changes in interest rates

Answer 6

Interest Rate Risk (or Yield Risk); as IR UP, value of fixed income DOWN

Question 7

Types of Risk: fluctuations in value as a result of operating within an economy; nondiversifiable risk (war, inflation, political events)

Answer 7

Market/systematic/nondiversifiable risk

Question 8

Types of Risk: portion of a firm’s or industry’s risk that is associated with random causes and can be eliminated through diversification

Answer 8

Diversifiable risk/unsystematic/firm-specific

Question 9

2 Broad categories of risk (DUNS)

Answer 9

D Diversifiable Risk
U Unsystematic Risk (nonmarket/firm-specific)
N Nondiversifiable risk
S Systematic risk (market)

Question 10

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

Answer 10

Credit Risk

Question 11

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

Answer 11

Default Risk

Question 12

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

Answer 12

Liquidity Risk

Question 13

Types of Risk: represents the exposure that investors have to a decline in the value of their individual securities or portfolios

Answer 13

Price Risk

Question 14

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

Answer 14

Stated Interest Rate (NO MATH) (SAR- annual)

Question 15

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?

Answer 15

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.)

Question 16

Computation of Return: represents a noncompounded version of the effective annual % rate
Computation?

Answer 16

Annual Percentage Rate (APR)

Effective periodic rate * # periods in a year

Question 17

Computation of Return: represents the stated interest rate (SAR) adjusted for the number of compounding periods per year
Computation?

Answer 17

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

Question 18

Computation of Return: amount represented by interest paid only on the original amount of principal without regard to compounding
Computation?

Answer 18

Simple Interest (total interest over life of loan)

PSAR# of years

Also, P(i)(n)

Question 19

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?

Answer 19

Compound Interest

P * (1 + Effective periodic)^Total #periods

-effective is expressed as a decimal

OR
Future Value = P (1+i)^n

Question 20

Required rate of return calculation

Answer 20

Risk-Free Rate + maturity risk premium (MRP) + purchasing power risk/inflation premium (IP) + Liquidity risk premium (LP) + Default risk premium (DP)

Question 21

Mitigating Risks: Ways to mitigate Diversifiable risk

Answer 21

Diversification (building a portfolio of investments of different and offsetting risks)

Question 22

Mitigating Risks: Ways to mitigate interest rate risk

Answer 22

-Investing in floating rate debt securities
-Derivatives (i.e. forward rate agreements or interest rate swaps)

Question 23

Mitigating Risks: Ways to Mitigate Market Risk

Answer 23

-NONDIVERSIFIABLE so not as easy to mitigate
-Invest in derivatives that provide gains to the investor when the market declines
-Short Selling

Question 24

Mitigating Risks: Ways to Mitigate Unsystematic Risk

Answer 24

Diversification

Question 25

Mitigating Risks: Ways to Mitigate Liquidity Risk

Answer 25

Allocating a greater percentage of capital to investments that trade on active markets, such as equities, corporate bonds, futures contracts, and options

Question 26

An option to sell a specific security at fixed conditions of price and time

Answer 26

Put option

Question 27

An option to buy a specific security at fixed conditions of price and time

Answer 27

Call option

Question 28

The risk associated with the unique circumstance of a particular company as they might affect the shareholder value of that company

Answer 28

Business risk (inherent if a firm only utilizes equity financing)

Question 29

The point at which the investor is indifferent to risk

Answer 29

Certainty Equivalent
Interpretation: If certainty equivalent > expect return on an investment, the investor is actually seeking lower return for higher risk (Risk Seeking behavior)

Question 30

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?

Answer 30

Amount expected * 1.xx * 1.xx (where xx is the inflation rate and over a two year period)

200,0001.061.06 = 224,720

Question 31

Risk Premium: compensation that investors demand for exposure to interest rate risk over time

Answer 31

Maturity Risk Premium (MRP)
*risk increases with term to maturity

Question 32

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

Answer 32

Purchasing power risk or inflation premium (IP)
*used to calculate the nominal RF

Question 33

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

Answer 33

Liquidity risk premium (LP)

Question 34

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

Answer 34

Default Risk Premium (DRP)