Risk Management

Question 1

Define: Market Risk

Answer 1

Market Risk is the risk that a sluggish economy will affect the value of a debt instrument.

Question 2

Define: Sector Risk

Answer 2

Sector Risk refers to the risk that an event in the investment’s business sector will harm the investment.

For example:

The banking sector is sluggish, so even stocks of healthy banks suffer.

Question 3

Define: Credit/Default Risk

Answer 3

Credit/Default Risk refers to 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

Interest Rate Risk is the risk that a change in interest rates will adversely affect the value of the note.

Example:

Bond is for 10% but prevailing market rate is now 12%. If bondholder wants to sell it, they will have to sell it at a discount.

Question 5

What does Standard Deviation measure?

Answer 5

Standard Deviation measures the volatility of an investment.

Question 6

What is Systematic Risk?

Answer 6

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

Example: Wars

Question 7

What is Unsystematic Risk?

Answer 7

Unsystematic Risk relates to a particular industry or company.

Example:

You own stocks in ethanol plants and an untimely freeze kills all of the corn in the Midwest.

Question 8

What does Beta measure?

Answer 8

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

In other words, how quickly (and in what amount) does the value of the stock change when the market sways?

Question 9

What is Variance?

Answer 9

Variance compares the volatility of an investment to the market average.

Factors include both Systematic and Unsystematic Risk.

Question 10

What is a Derivative?

Answer 10

A Derivative is an asset whose value is DERIVED from the value of another asset.

Derivatives are measured at Fair Value.

Question 11

How is an Option used?

Answer 11

An Option gives the buyer the option to buy or sell a financial derivative at a certain price.

• Traders use them to speculate where they think the
  price will be at a certain point and make a profit.
• Hedgers use them to offset risk.

Question 12

What is a Future?

Answer 12

A Future is a Forward Contract 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. They are highly liquid and often valued using the Zero-Coupon method.

Example:

Steve pays Sally a fixed payment with a fixed interest rate. Sally pays Steve a variable payment tied to a benchmark such as LIBOR.

Question 14

What is Legal Risk?

Answer 14

Legal Risk is risk that a law or regulation will void the derivative.

Question 15

What is a Fair Value Hedge?

Answer 15

Fair Value Hedge is a hedge that protects against the value of an asset or liability changing.

Changes in value are reported in earnings.

Question 16

What is a Cash Flow Hedge?

Answer 16

A Cash Flow Hedge is a hedge that protects against a set of future cash flows changing.

Changes in value are reported in OCI.

Question 17

What is a Foreign Currency Hedge?

Answer 17

A Foreign Currency Hedge is a hedge that protects against the value of a foreign currency changing.

For example:

A foreign currency hedge might be used to protect against the following:

If you have receivables denominated in a foreign currency and that currency dips in value. your receivables are worth less than before.