Module 43:Financial Risk Management Flashcards
(37 cards)
What is Geometric Average?
An investment that is expected to be held for a long period of time. will always fall below the arithmetic average.
Who are Risk-neutral investors?
Investors that prefer investments with higher returns whether or not they have risk. These investors disregard risk.
Who are Risk-seeking investors?
Investors that prefer to take risks and would invest in a higher-risk investment despite the
fact that a lower-risk investment might have the same return.
What is investment return? (Also called return on a single asset)
The total gain or loss on an investment for a period of time.
Formula: Rt + 1 =Pt + 1 – Pt + CFt + 1/Pt
What is Arithmetic Average?
Used for assets with short holding periods. Will always be above Geometric Average.
What is the relationship between risk and return?
Direct. Higher returns are associated with higher degrees of risk.
The expected return of a portfolio is measured by?
Weighted Average.
E(RP) = w1E(R1) + w2E(R2) + w3E(R3)…
What is Beta (aka Coeffecient variance) used for ?
-To measure how risky a stock is.
-Used to measure systematic risk
Formula: Standard Deviation %/Expected rate of return%
What is Unsystematic risk? Can investors theoretically eliminate the risk? And if so, how?
- The risk that exists for one particular investment or a group of like investments.
- Yes, investors can theoretically eliminate this risk.
- By having a balanced portfolio.
- Portfolios allow investors to diversify away unsystematic risk.
What is Systematic risk? Can investors theoretically eliminate the risk? And if so, how?
- All investments are to some degree affected by them.
- No, investors cannot theoretically eliminate this risk.
- Relates to market factors that cannot be diversified away.
- Measured using Beta
What is a stated rate?
The contractual rate charged by the lender
What is an effective annual rate?
The true annual return to the lender.
Formula: EAR =(1+ (r/m^ 4))-1
m −1
What is a normal yield curve?
An upward sloping curve in which short-term rates are less than intermediate-term rates which are less than long-term rates.
What is an inverted (abnormal) yield curve?
A downward-sloping curve in which short-term rates are greater than intermediate-term rates which are greater than long-term rates.
What is a flat yield curve?
A curve in which short-term, intermediate-term and long-term rates are all about the same.
What is a humped yield curve?
A curve in which intermediate-term rates are higher than both short-term and long-term rates.
What does the Liquidity preference (premium) theory state?
Liquidity preference (premium) theory. This theory states that long-term rates should be higher than short term
rates, because investors have to be offered a premium to entice them to hold less liquid and more price sensitive
securities. Remember if interest rates increase and an investor holds a fixed-rate long-term security,
the value of the security will decline.
What does the Market segmentation theory state?
States that treasury securities are divided into market segments by the various financial institutions investing in the market. Commercial banks prefer short-term securities to match their short-term lending strategies. Savings and loans prefer intermediate-term securities. Finally, life insurance companies prefer long-term securities because of the nature of their commitments to policyholders. The demand for various term securities is therefore dependent on the demands of these segmented groups of investors.
What does the expectations theory state?
Explains yields on long-term securities as a function of short-term rates. Specifically, it states that long-term rates reflect the average of short-term expected rates over the time period that the long-term security will be outstanding. Under this theory long-term rates tell us about market expectations of short-term rates. When long-term rates are lower than short-term rates, the market is expecting short-term rates to fall. Since interest rates are directly tied to inflation rates, long-term rates also tell us about the market’s expectations about inflation. If long-term rates are lower than short-term rates, the market is indicating a belief that inflation will decline.
What are options? (A type of derivative)
Allow, but do not require, the holder to buy (call) or sell (put) a specific or standard commodity or
financial instrument, at a specified price during a specified period of time (American option) or at a specified date (European option).
What are forwards? (A type of derivative)
Negotiated contracts to purchase and sell a specific quantity of a financial instrument, foreign
currency, or commodity at a price specified at origination of the contract, with delivery and payment at a
specified future date.
What are futures? (A type of derivative)
Forward-based standardized contracts to take delivery of a specified financial instrument, foreign
currency, or commodity at a specified future date or during a specified period generally at the now market price.
What are currency swaps? (A type of derivative)
Forward-based contracts in which two parties agree to exchange an obligation to pay cash flows in one currency for an obligation to pay in another currency.
What are interest rate swaps? (A type of derivative)
Forward-based contracts in which two parties agree to swap streams of payments over a specified period of time. An example would be an interest-rate swap in which one party agrees to make payments based on a fixed rate of interest and the other party agrees to make payments based on a variable rate of interest.
