Risk Concepts—Summary-Financial Management

Question 1

Are the following fixed-rate investments subject to interest rate risk during their life?

Domestic Bonds International bonds U.S. Treasury Bills

Answer 1

Domestic Bonds International bonds
Yes Yes
U.S. Treasury Bills
Yes

All fixed-rate debt investments have an interest rate risk associated with them. Specifically, the risk is that the market rate of interest will go up, causing the value of outstanding debt (issued at a lower interest rate) to go down.

Question 2

Company specific risk is also known as which one of the following?

    A.  	Market-related risk.
B.  	Business risk.
C.  	Unsystematic risk.
D.  	Non-diversifiable risk.

Answer 2

C. Unsystematic risk.

Company specific risk (also called firm-specific risk and diversifiable risk) are unsystematic risk. This risk includes those elements of business risk that can be eliminated through diversification. Specifically, this risk can be mitigated by diversification of projects, investments, etc.

Question 3

Which of the following factors is inherent in a firm's operations if it utilizes only equity financing?
	A.  	Financial risk.
	B.  	Business risk.
	C.  	Interest rate risk.
	D.  	Marginal risk.

Answer 3

B. Business risk.

A firm that utilizes only equity financing would face business risk. Business risk derives from the broad, macro-risk a firm faces largely as a result of the relationship between the firm and the environment in which it operates. The extent of that risk would depend on the susceptible of the firm to changes in the overall economic climate.

Question 4

Which of the following factors is inherent in a firm’s operations if it utilizes only debt financing?

Answer 4

Financial risk is the additional risk a firm bears when it uses debt in addition to equity financing. In general, firms that issue more debt would have higher (financial) risk than firms financed entirely by equity

Question 5

What is Interest rate risk?

Answer 5

Interest rate risk is the risk associated with the effects of change in the market rate of interest on debt. A firm which utilizes only equity financing would not have interest rate risk (as a debtor). Note, however, that if the firm invests in debt instruments (as opposed to issuing debt), its investments would have interest rate risk!

Question 6

A company has several long-term floating-rate bonds outstanding. The company’s cash flows have stabilized, and the company is considering hedging interest rate risk. Which of the following derivative instruments is recommended for this purpose?

    A.  	Structured short-term note.
B.  	Forward contract on a commodity.
C.  	Futures contract on a stock.
D.  	Swap agreement.

Answer 6

D. Swap agreement.

A swap agreement would be recommended to hedge interest rate risk on long-term floating-rate bonds. In an interest rate swap agreement one stream of future interest payments (e.g., floating-rate payments) is exchanged for another stream of future interest payments (e.g., fixed-rate payments) for a specified principal amount. In this case, an interest rate swap would hedge (mitigate) exposure to fluctuations in interest rates of the floating-rate bonds by exchanging those payments for a fixed-rate payment.

Question 7

A firm with cash in excess of its immediate needs is considering a temporary investment in newly issued 10-year treasury obligations, which pay a fixed rate of interest.
If the investment will be for one year, which of the following risks, if any, would be of concern?
Default Risk Interest Risk
Yes Yes
Yes No
No Yes
No No

Answer 7

Default Risk Interest Risk
No Yes
Debt obligations of the U.S. government are considered to be free of the risk of default, therefore risk of default on the debt would not be of concern. Interest rate risk would be of concern. Interest rate risk derives from the effects on market value resulting from changes in the rate of interest in the market. If the interest rate increases relative to the rate at the time the fixed-rate Treasury obligations are acquired, the market value of the Treasury obligations will decrease (and vice versa).

Furthermore, the longer the maturity of the fixed-rate obligations, the greater the influence of a given interest rate change on current market value. Since the Treasury obligation is to be sold in one year, not held to maturity, the value of the obligations at the date of sale will depend on the market interest rate at that time relative to the rate when the obligations are acquired.

Question 8

Which one of the following named risks cannot be mitigated through diversification of investments?
	A.  	Unsystematic risk.
	B.  	Systematic risk.
	C.  	Firm-specific risk.
	D.  	Company unique risk.

Answer 8

B. Systematic risk.

Systematic risk, also called non-diversifiable risk or market-related risk, cannot be mitigated or eliminated through diversification of investments. This type of risk is most closely associated with elements of the macroeconomic environment in which a firm operates and would include, for example, interest rate risk and inflation risk.

Question 9

Which of the following types of risk can be reduced by diversification?

   A.  	High interest rates.
B.  	Inflation.
C.  	Labor strikes.
D.  	Recession.

Answer 9

C. Labor strikes.

Risks that can be reduced by diversification (also called diversifiable risk or unsystematic risk) are risks that relate to a particular undertaking, firm or industry, and typically are not associated with macroeconomic conditions. Diversifiable risk are mitigated by engaging in multiple different investments or undertakings so that an unexpected unfavorable outcome of one investment or undertaking will represent only a small portion of all investments or undertakings and so that unfavorable outcomes on some investments or undertakings will be offset by favorable outcomes on other investments or undertakings. Labor strikes typically are peculiar to a particular undertaking, plant, firm or industry and are, therefore, diversifiable by having labor forces in other undertakings, plants, or industries.

Question 10

If a CPA's client expected a high inflation rate in the future, the CPA would suggest to the client which of the following types of investments?
	A.  	Precious metals.
	B.  	Treasury bonds.
	C.  	Corporate bonds.
	D.  	Common stock.

Answer 10

A. Precious metals

Of the alternative answer choices listed, during a period of high inflation, the best investment is precious metals. Because of their scarcity, precious metals tend to increase in market value during periods of inflation. Treasury bonds and corporate bonds, both of which typically pay fixed rates of return, face market interest rate risk and will lose market value as inflation drives up the general rate of interest. While common stock may provide some protection during a period of high inflation, that inflation causes the costs of productive inputs to increase, therefore, increasing pressure on company profits and returns to common stock shareholders.