Risk Concepts Flashcards
Define “risk”.
The possibility of loss or other unfavorable outcome that results from the uncertainty in future events.
Describe diversifiable risk (also called unsystematic risk, firm-specific risk, or company-unique risk). Describe diversifiable risk (also called unsystematic risk, firm-specific risk, or company-unique risk).
Elements of business risk that can be eliminated through diversification of investments; for example diversification of projects or securities investments.
Describe nondiversifiable risk (also called systematic risk or market-related risk).
Elements of risk that cannot be eliminated through diversification of investments; usually derive from general economic and political factors (e.g., general level of interest rate, new taxes, inflation/deflation, etc.).
What is EBIT?
Earnings before interest and taxes. Measures the results of a firm’s operating activities (except debt financing). Greater variability in EBIT, greater the perceived business risk.
Describe financial risk.
Risk to common shareholders that derives from a firm’s use of debt financing which requires interest payment regardless of the firm’s operating results and its use of preferred stock which requires payment of dividends before common shareholders receive dividends.
Describe default risk.
The risk associated with the possibility that the issuer of a security will not be able to make future interest payments and/or principal repayment.
Describe interest rate risk.
Risk to investors associated with the effects of changes in the market rate of interest on outstanding fixed-rate debt instruments. If the market rate of interest increases, the market value of already outstanding fixed-rate debt instruments will decrease.
Describe inflation risk (also called purchasing power risk).
The risk that a rise in the general price level (inflation) will result in reduced purchasing power of a fixed sum of money.
Describe liquidation risk (also called marketability risk).
The risk associated with the possibility that an asset cannot be readily sold for cash equal to its fair value.
Describe Political Risk.
Risk associated with operations in a foreign country that has different political, governmental, cultural, ethical, market structure, or other socio-political elements than a firm’s domestic market.
Describe currency exchange risk.
Risk that derives from changes in exchange rates between currencies; may affect foreign currency transactions, foreign currency investments and/or future foreign currency economic activity.
