Module 43a: Financial Risk Management Flashcards
there is a trade off between risk and returns when considering investments
to achieve higher returns an investor must assume greater risk
variance is the term used for
higher risk
equity risk premium
equal to the real return on stocks minus the risk-free real return as measured by the treasury bills
chart on page 192
average risk premium on common stock versus bonds over the ten year period (page 192)
is mean return on stocks minus mean return on bonds
risk averse
most financial models assume that investors are risk averse
risk aversion does not mean investors will not take risks; it means that they must be compensated for taking a risk
most investors and the market as a whole are considered by most analysts to be risk averse
however, certain investors may exhibit different behavior
risk neutral investors
investors that prefer investments with higher returns whether or not they have risk
these investors disregard risk
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
investment return
the total gain or loss on an investment for a period of time
consists of the change in the asset’s value (either gain or loss) plus any cash distribution (cash flow, interest, dividends)
ex post basis
“after the fact” investment return formula
therefore it does not consider risk
ex ante basis
managers have to evaluate investments on an ex ante basis and therefore must use expexted returns and estimates of risk
estimating expected returns
a common way to do this is based on prior history
one could simply calculate the average historical returns on a similar investment to get the expected return
two approaches are often used in making this computation:
- arithmetic average return
- geometric average return
arithmetic average return
computed by simply adding the historical returns for a number of periods and dividing by the number of periods
generally recommended that arithmetic average be used for assets with short holding periods (vs longer holding periods)
geometric average return
this computation depicts the compound annual return earned by an investor who bought the asset and held it for the number of historical periods examined
if returns vary through time, the geometric average will always fall below the arithmetic average
it is recommended that geometric average be used for assets with longer holder periods (vs short holding periods)
estimating risk
measures of risk are often developed from historical returns
the pattern of historical returns of large numbers of similar investments approximates a nomal distribution (bell shaped curve) with the mean being the expected return and the variance, or standard deviation, measuring the dispersion around the expected return
**if you assume that the distribution is normal, about 95% of the returns will fall within the range created by expected return plus/minus two standard deviations
coefficient of variation
a measurement of risk, where a lower number is less risky (the higher the number the riskier)
=standard deviation/expected return
when an investor invests in a portfolio of assets, the expected returns are simply
the weighted average of the expected returns of the assets making up the portfolio
Expected return on the portfolio= (the weight of asset1)(expected return on asset1) + etc of 2
the variance of portfolio returns
depends on three factors:
- the percentage of the portfolio invested in each asset (the weight)
- the variance of the returns of each individual asset
- the covariance among the returns of assets in the portfolio
Covariance
the covariance captures the degree to which the asset returns move together over time
if returns on the individual assets move together, there is little benefit to holding the portoflio
on the other hand, if returns on some assets in the portfolio go up when returns on other assets in the portfolio go down, holding the portfolio reduces overall risk
portfolios allow investors to diversify away unsystematic risk
unsystematic risk= the risk that exists for one particular ivnestment or a group of like investments (e.g. technology stock)
by having a balanced portfolio, investors can theoretically eliminate this risk
systematic risk
relates to the market factors that cannot be diversified away
all investments are to some degree affected by them
examples: fluctuations in GDP, inflation, interest rates, etc.
beta
it measures how the value of a particular investment moves along with the market (chanes in the value of the portfolio)
it can be used to evaluate the effect of an individual investments risk on the risk of the entire portfolio
risk preference function
an individual investor has a risk preference function, which describes the investor’s trade-off between risk and return
a portfolio that falls on the line described by this function is an efficient portfolio
interest rates
represent the cost of borrowing funds
credit or default risk
the risk that th firm will default on payment of interest or principal of the loan or bond
this may be divided into two parts:
- the individual firm’s creditworthiness (or risk of default) and
- sector risk- the risk related to economic conditions in the firm’s economic sector
credit risk is an example of unsystematic risk that you can diversify away
credit risk can be eliminated by diversification (investing in a portfolio of loans or bonds)
interest rate risk
the risk that the value of the loan or bond will decline due to an increase in interest rates
part of systematic risk that must be accepted by the investor
something with risk payment that is fixed- if interest rate goes up, since yours is valued at a fixed investment, the value of yours is going to go down
market risk
the risk that the value of a loan or bond will decline due to a decline in the aggregate value of all the assets in the economy
part of systematic risk that must be accepted by the investor
recession or depression
business risk
in determining the appropriate interest rate to accept, investors and creditors consider the business risks of the loan or investment
relevant business risks are:
- credit or default risk
- interest rate risk
- market risk
in order to put interest rates on a common basis for comparison,
management must distinguish between the stated interest rate and the effective annual interest rate
stated interest rate
the contractual rate charged by the lender
effective annual interest rate
the true annual return to the lender
the simple annual rate may vary from the effective annual rate because interest is often compounded more often than annually
the term structure of interest rates
describes the relationship between long and short term raes
these relationships are important in determining whether to use long-term fixed or variable rate financing
a yield curve is used to illustrate the relative level of short term and long term interest rates at a point in time
possible yield forms:
- normal yield curve
- inverted (abnormal) yield curve
- flat yield curve
- humped yield curve
page 195
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
ST < IR < LT
inverted (abnormal)yield curve
a downward sloping curve in whcih short term rates are greater than intermediate term rates which are greater than long term rates
ST > IR > LT
flat yield curve
a curce in which short term, intermediate term, and long term rates are all about the same
ST = IR = LT
humped yield curve
a curve in which intermediate term rates are higher than both short term and long term rates
IR > ST & LT
maturity risk premiums
required for long-term lending because long-term rates are usually higher because they involve more risk (as described in the normal yield curve)
theories that attempt to explain the yield curve
- liquidity preference (premium) theory
- market segmentation theory
3 expectations theory
liquidity preference (premium) 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 an investor holds a fixed rate long-term security and interest rates increase, the value of the security will decline
market segmentation theory
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
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
expectations theory
explains yields on long-term securities as a function of short-term rates
specifically, it states that long-term rates reflect the average 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
if long-term rates are lower than short term rates, the market is expecting short term rates to fall and the market is indicating that inflation wil decline
all interest rate theories make it difficult to predict interest rates in general therefore,
sound financial policy calls for using a combination of long term and short term debt and equity to enable the firm to survive at any interest rate environment
the mix of long term and short term debt affect a firms financial statements….
a heavy reliance on short term or variable rate debt means that interest expense and therefore net income will be more variable
this increases the financial risk of the firm and will cause creditors and investors to demand higher rates to compensate for the increased risk
derivative
a financial instrument or contract whose value is derived from some other financial measure (underlyings, such as commodity prices, stock prices, interest rates) and includes payment provisions
common examples of derivatives:
- options
- forwards
- futures
- currency swaps
- interest rate swaps
- swaption
options
allow but do not rewuire 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)
forwards
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
not standardized
futures
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 then market price
much more specific than forwards (were going to sell you 200 boxes of corn for $50,000 between september 1 and 15th)
standardized and can trade in the futures market
currency swaps
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
interest rate swaps
forward-based contracts in which two parties agree to swap streams of payments over a specified period of time
example: one party agrees to make payments based ona fixed rate of interest and the other party agrees to make payments based on a variable rate of interest
swaption
an option of a swap that provides the holder with the right to enter into a swap at a specified future date with specific terms, or to extend or terminate the life of an existing swap
these derivatives have characteristics of an option and interest rate swap
forward contracts and swaps are often created and exchanged by financial intermediaries, such as
commercial banks insurance companies pension funds savings and loan associations mutual funds finance companies investment bankers money market funds credit unions
counterparty
the other party to the contract or agreement
risks in using derivatives
- credit risk
- market risk
- basis risk
- legal risk
credit risk (derivatives)
the risk of loss as a result of the counterparty to a derivative agreement failing to meet its obligation
market risk (derivatives)
the risk of loss from adverse changes in market factors that affect the fair value of a derivative
such as interest rates, foreign exchange rates, and market indexes for equity securities
basis risk (derivatives)
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 will change so that the hedge will no longer be effective
legal risk (derivatives)
the risk of loss from a legal or regulatory action that invalidates or otherwise precludes performance by one or both parties to the derivative agreement
use of derivatives
- speculation: as an investment to speculate on price changes in various markets
- hedging: to mitigate a business risk that is faced by the firm. hedging is 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.
FASB ASC Topic 815 provides guidance on three types of hedging activities
- fair value hedge
- cash flow hedge
- foreign currency hedge
fair value hedge
of a recognized asset or liability or of an unrecognized firm committment
a hedge of the changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk
executory contract or purchase order
cash flow hedge
of a recognized asset or liability or of a forecasted transaction
a hedge of the variability in the cash flows of a recognized asset or liability, or of a forecased transaction, that is attributable to a particular risk
you’re thinking about it
foreign currency hedges
- a fair value hedge of an unrecognized firm commitment or a recognized asset or liability valued in a foreign currency (a foreign currency fair value hedge)
- a cash flow hedge of a forecaseted transaction, an unrecognized firm commitment, the forecasted functional-currency-equivalent cash flows associated with a recognized asset or liability, or a forecasted intercompany transaction (a foreign currency cash flow hedge)
- a hedge of a net investment in a foreign operation
* treated like a fair value hedge or a cash flow hedge
3 types of securities
- treasury bills- 90 days
- treasury notes- 1 year
- treasury bonds- 15 years
in general Topic 815 requires an entity to report all derivatives as assets and liabilities on the
balance sheet (statement of financial position) measured at fair value (written up or down)
unrealized gains and losses attributed to changes in a derivative’s fair value are accounted for DIFFERENTLY, depending on whether the derivative is designated and qualifies as a hedge
accounting for a fair value hedge
there is an effective portion and an ineffective portion –> both go to income from continuing operations
accounting for any derivative held for speculative reasons
the unrealized holding gains go to income from continuing operations– show up in net income
accounting for a cash flow hedge
there is an effective portion and an ineffective portion
the effective portion goes to other comprehensive income and is reported net of the tax effect
the ineffective portion goes to income from continuing operations
accounting for foreign currency operations
treated like fair value hedge or foreign currency hedge
value derivatives at
fair value
thats why they have unrealized gains or losses
two ways to value derivatives
- Black-Sholes option-pricing model
2. Zero-coupon method
Black-Sholes option-pricing model
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
this is the option used to value a derivative when there is no quoted market price
other methods used to value options include monte-carlo simulation and binomial trees
Zero-coupon method
used to determine the fair value of interest rate swaps
a present value model in which the net settlements from the swap are estimated and discounted back to their current value
key variables in the model include:
- estimated net settlement cash flows
- timing of the cash flows as specified by the contract
- discount rate
bonds
generally provide for periodic fixed interest payments at a coupon (contract) rate of interest
at issuance, or thereafter, the market rate of interest for the particular type of bond may be above, the same, or below the coupon rate
discounted bond
if the market rate exceeds the coupon rate, the book value will be less than the maturity value
premium bond
the coupon rate exceeds the market rate, the bond will sell for more than maturity value to bring the effective rate to the market rate
par bond
when the coupon rate and the market rate equal each other
coupon rate contract rate stated rate nominal rate bond rate
all the same thing
mean: rate of interest that is paid to bondholders
market rate effective rate yield yield to maturity real rate
the market rate of interest for your bonds that are similar to yours
aka if someone is offering you a bond paying 6% and the market rate is 8% that bond is at a discount and you dont want it because you can go elsewhere and get the 8% bond
