Module 43:Financial Risk Management

Question 1

What is Geometric Average?

Answer 1

An investment that is expected to be held for a long period of time. will always fall below the arithmetic average.

Question 2

Who are Risk-neutral investors?

Answer 2

Investors that prefer investments with higher returns whether or not they have risk. These investors disregard risk.

Question 3

Who are Risk-seeking investors?

Answer 3

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.

Question 4

What is investment return? (Also called return on a single asset)

Answer 4

The total gain or loss on an investment for a period of time.
Formula: Rt + 1 =Pt + 1 – Pt + CFt + 1/Pt

Question 5

What is Arithmetic Average?

Answer 5

Used for assets with short holding periods. Will always be above Geometric Average.

Question 6

What is the relationship between risk and return?

Answer 6

Direct. Higher returns are associated with higher degrees of risk.

Question 7

The expected return of a portfolio is measured by?

Answer 7

Weighted Average.

E(RP) = w1E(R1) + w2E(R2) + w3E(R3)…

Question 8

What is Beta (aka Coeffecient variance) used for ?

Answer 8

-To measure how risky a stock is.
-Used to measure systematic risk
Formula: Standard Deviation %/Expected rate of return%

Question 9

What is Unsystematic risk? Can investors theoretically eliminate the risk? And if so, how?

Answer 9

• 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.

Question 10

What is Systematic risk? Can investors theoretically eliminate the risk? And if so, how?

Answer 10

• 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

Question 11

What is a stated rate?

Answer 11

The contractual rate charged by the lender

Question 12

What is an effective annual rate?

Answer 12

The true annual return to the lender.
Formula: EAR =(1+ (r/m^ 4))-1
m −1

Question 13

What is a normal yield curve?

Answer 13

An upward sloping curve in which short-term rates are less than intermediate-term rates which are less than long-term rates.

Question 14

What is an inverted (abnormal) yield curve?

Answer 14

A downward-sloping curve in which short-term rates are greater than intermediate-term rates which are greater than long-term rates.

Question 15

What is a flat yield curve?

Answer 15

A curve in which short-term, intermediate-term and long-term rates are all about the same.

Question 16

What is a humped yield curve?

Answer 16

A curve in which intermediate-term rates are higher than both short-term and long-term rates.

Question 17

What does the Liquidity preference (premium) theory state?

Answer 17

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.

Question 18

What does the Market segmentation theory state?

Answer 18

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.

Question 19

What does the expectations theory state?

Answer 19

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.

Question 20

What are options? (A type of derivative)

Answer 20

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).

Question 21

What are forwards? (A type of derivative)

Answer 21

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.

Question 22

What are futures? (A type of derivative)

Answer 22

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.

Question 23

What are currency swaps? (A type of derivative)

Answer 23

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.

Question 24

What are interest rate swaps? (A type of derivative)

Answer 24

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.

Question 25

What is a swaption? (A type of derivative)

Answer 25

An option of a swap that provides the holder with the right to enter into a swap at a specified future date with specified terms, or to extend or terminate the life of an existing swap. These derivatives have characteristics of an option and an interest rate swap.

Question 26

What is a derivative?

Answer 26

A financial instrument or contract whose value is derived from some other financial measure (underlyings, such as commodity prices, stock prices, interest rates, etc.) and includes payment provisions.

Question 27

Forward contracts and swaps are often created and exchanged by?

Answer 27

Financial intermediaries

Question 28

What are derivatives used for?

Answer 28

1) Speculation— As an investment to speculate on price changes in various markets.
2) Hedging— To mitigate a business risk that is faced by the firm.

Question 29

What is hedging?

Answer 29

An activity that protects the entity against the risk of adverse changes in the fair values or cash flows of assets, liabilities, or future transactions. A hedge is a defensive strategy.

Question 30

What is a basis risk?

Answer 30

The risk of loss from ineffective hedging activities. Basis risk is the difference between the fair value (or cash flows) of the hedged item and the fair value (or cash flows) of the hedging derivative. The entity is subject
to the risk that fair values (or cash flows) will change so that the hedge will no longer be effective.

Question 31

What does the Statement of Financial Accounting Standard (SFAS 133) require an entity to report all derivatives as?

Answer 31

Assets and liabilities in the statement of financial

position, measured at fair value.

Question 32

If quoted market prices aren’t available to value derivatives, what are some valuation techniques?

Answer 32

1) Black-Scholes option-pricing model
2) zero-coupon method
3) Monte-Carlo simulation
4) binomial trees.

Question 33

What is the Black-Scholes option-Pricing model?

Answer 33

a mathematical model for estimating the price of stock options, using the following five variables:
• Time to expiration of the option
• Exercise or strike price
• Risk-free interest rate
• Price of the underlying stock
• Volatility of the price of the underlying stock

Question 34

What is the Zero-Coupon Method?

Answer 34

Used to determine the fair value of interest rate swaps. Is a present value model in which the net settlements from the swap are estimated and discounted back to their
current value. The key variables in the model include:
• Estimated net settlement cash flows
• Timing of the cash flows as specified by the contract
• Discount rate

Question 35

When a firm finances each asset with a financial instrument of the same approximate maturity as the life of the asset, it is applying what approach?

Answer 35

A hedging approach

Question 36

It is a future value problem if?

Answer 36

The total amount comes at the end of the series of payments.

Question 37

It is a present value problem if?

Answer 37

The total amount comes at the beginning of the series of payments