Risk Management

Question 1

Define Market Risk Systematic

Cannot diversify

Answer 1

The risk that a sluggish economy will affect the value of a debt instrument

Question 2

Define Sector Risk

Answer 2

The risk that an event in the investment’s business sector will harm the investment

Question 3

Define Credit/Default Risk

Answer 3

The risk that a debtor will be unable to make loan payments or pay back the principal

Question 4

Define Interest Rate Risk

Answer 4

The risk that a change in interest rates will adversely affect the value of the note

Question 5

What does Standard Deviation measure?

Answer 5

Dispersion about Mean

2 Standard Deviations = 95%

It measures the volatility of an investment.

Question 6

What is Systematic Risk?

Answer 6

Risk that impacts the entire market and can’t be avoided or reduced through diversification

Question 7

What is Unsystematic Risk?

Answer 7

Relates to a particular industry or company

Can be diversified

Question 8

What does Beta measure?

Answer 8

Beta measures how volatile the investment is relative to the rest of the market

How quickly (and in what amount) does the value change when the market sways?

Question 9

What is Variance?

Portfolio Variance?

Answer 9

It compares volatility of an investment to the market average.

Factors include both Systematic and Unsystematic Risk.

1. % of portfolio invested in each asset (weight)
2. variance of returns of each asset
3. covarsiance among asset returns

Question 10

What is a Derivative?

Answer 10

An asset whose value is DERIVED from the value of another asset

Underlying and payment provisions

Derivatives are measured at Fair Value.

Question 11

How is an Option used?

Answer 11

Gives the buyer the option to buy or sell a financial derivative at a certain price

…at specified period of time (American)

…at a specified date (European)

Question 12

What is a Future?

Answer 12

A Forward Contract with standardized contract

Tradeable with a future value.

They are sold and traded on the futures market.

Question 13

What is an Interest Rate Swap?

Answer 13

Forward Contract to swap payment agreements

Different streams of payments over a fixed period of time

They are highly liquid and often valued using the Zero-Coupon method.

Ex: one party pays fixed rate, other pays variable

Question 14

What is Legal Risk?

Answer 14

Risk that a law or regulation will void the derivative

Question 15

What is a Fair Value Hedge?

Answer 15

Hedge that protects against the value of an asset, liability, or unrecognized firm committment changing.

Changes in value are reported in earnings.

Offset by change in FV of asset/liability

Question 16

What is a Cash Flow Hedge?

Answer 16

A hedge that protects against a set of future cash flows changing.

Effective portion changes in value are reported in OCI.

Ineffective portion reported in earnings

Question 17

What is a Foreign Currency Hedge?

Answer 17

A hedge that protects against the value of a foreign currency changing:

• Fair Value
• Cash Flow
• Investment in operation

Question 18

What are the Black-Scholes Option-pricing Model variables (5)?

Answer 18

1. Time to expireation
2. Exercise or Strike price
3. Risk-free interest rate
4. Price of underlying stock
5. Volatility of price of underlying stock

Question 19

What is an Efficient Portfolio

Answer 19

Portfolio that falls on the investor’s risk preference function of risk-return trade-off

Question 20

Yield Curve Theories

Answer 20

1. Liquidity preference (premium) for less liquid investments
2. Market segmentation:
   
   • Commercial Banks - ST;
   • S&L - MT;
   • Life Insurance - LT
3. Expectations theory: Expected ST rates and inflation

Question 21

What is a Swaption

Answer 21

Option of an Interest Rate Swap

Question 22

Derivative risks

Answer 22

Credit

Market

Basis / effectiveness

Legal