Risk Management

Question 1

Define Market Risk

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

For example- the banking sector is sluggish- so even stocks of healthy banks suffer

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

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

It measures the dispersion of individual’s stock returns.

Volatility of investment

Question 6

What is Systematic Risk?

Answer 6

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

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.

Measure of systematic risk of investment

Positive = moves with portfolio
Negative = moves against portfolio (want this)

Question 9

What is Variance?

Answer 9

It compares volatility of an investment to the market average.

Depends on

• Portfolio weighting
• Variance of individual asset returns
• Covariance among returns of assets

Factors include both Systematic and Unsystematic Risk.

Question 10

What is a Derivative?

Answer 10

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

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 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

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 or liability changing.

Changes in value are reported in earnings.

Question 16

What is a Cash Flow Hedge?

Answer 16

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 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.

Question 18

What are the components of risk management?

Answer 18

Internal Environment
Objective Setting
Event Identification
Risk Assessment
Risk Response
Control Activities
Information and Communication
Monitoring

Question 19

What is the difference between risk appetite and risk tolerance?

Answer 19

Risk appetite is the amount of risk a firm is willing to accept to achieve its goals

Risk tolerance is the acceptable variation with respect to a particular objective

Question 20

How do you calculate the coefficient of variation and what does it measure?

Answer 20

= Standard Deviation / Expected Return

Compares risk of stock to expected return

Question 21

How do you calculate the effective annual interest rate?

Answer 21

1 + (Stated Annual Rate / Compounding Frequency)

To the power of the Compounding Frequency

Then subtract 1

Question 22

What is basis risk?

Answer 22

The risk that a derivative might be ineffective at hedging particular asset