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 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

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.

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

It compares volatility of an investment to the market average.

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

CAPM

Answer 18

Required rate of return (RRR)
RRR=Rf+£(Rm-Rf)
Rf-Rm market risk premium
£(Rm-Rf) security risk premium

Question 19

£ security risk

Answer 19

£=1 expected return = market return
£=0 US Treasury security
£=1.4 systematic risk is higher than that of the market

Question 20

€ sigma standard deviation

Answer 20

Measure riskiness of the investment, the smaller the lower risk

Question 21

r coefficient of correlation

Answer 21

1.0 -1.0
r=1 two variances move together
r=-1 unsystematic risk can be eliminated

Question 22

Sensitivity analysis

Answer 22

Examined how the model’s outcomes change as the parameters change

Question 23

Expected value analysis

Answer 23

Is used to determine an anticipated return or cost based upon probabilities of events and their related outcomes. It is arithmetic mean using probabilities as weights

Question 24

r coefficient if correlation

Answer 24

Us the strength of the linear relationship b/w 2 variables from 1 to -1. r=1 very strong relationship

Question 25

r^2 coefficient of determination

Answer 25

Measure of how good the fit b/w the independent and dependent variables is. The closer the value to 1 the more useful the independent variable

Question 26

WACC

Answer 26

One of the company’s objective is to minimize the wacc

Question 27

Trade related factors

Answer 27

Relative income
Trade barriers
Relative inflation rate

Question 28

Decision tree analysis

Answer 28

Diagram that analyze sequences of probabilistic decisions, the events that may follow each decision and their outcomes

Question 29

Linear programming

Answer 29

Used to minimize a cost function or maximize a profit function given constraints

Question 30

Queuing theory

Answer 30

Used to minimize the cost of waiting lines

Question 31

Monte Carlo simulation

Answer 31

Mathematical model, is a technique to generate the individual values for a random variable.
Adv: time can be compressed, alternative policies can be considered, complex system can be analyzed

Question 32

Delphi

Answer 32

Forecasting method relies mostly on judgment

Question 33

Econometric models

Answer 33

Apply statistical methods to the study of economic problem and data

Question 34

Sensitivity analysis

Answer 34

Examine how the models outcomes change as the parameters change

Question 35

Beta is equal 1.4

Answer 35

Systematic risk is higher than that if the market portfolio

Question 36

Ordinary annuity

Answer 36

Payment received at the end of period

Question 37

Annuity due

Answer 37

Payment is made in the beginning of the period