Risk Management

Question 2

Define Market Risk

Answer 2

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

Question 3

Define Sector Risk

Answer 3

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 4

Define Credit/Default Risk

Answer 4

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

Question 5

Define Interest Rate Risk

Answer 5

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 6

What does Standard Deviation measure?

Answer 6

It measures the volatility of an investment.

Question 7

What is Systematic Risk?

Answer 7

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

Question 8

What is Unsystematic Risk?

Answer 8

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 9

What does Beta measure?

Answer 9

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 10

What is Variance?

Answer 10

It compares volatility of an investment to the market average. Factors include both Systematic and Unsystematic Risk.

Question 11

What is a Derivative?

Answer 11

An asset whose value is DERIVED from the value of another asset. Derivatives are measured at Fair Value.

Question 12

How is an Option used?

Answer 12

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 13

What is a Future?

Answer 13

A Forward Contract with a future value. They are sold and traded on the futures market.

Question 14

What is an Interest Rate Swap?

Answer 14

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 15

What is Legal Risk?

Answer 15

Risk that a law or regulation will void the derivative

Question 16

What is a Fair Value Hedge?

Answer 16

Hedge that protects against the value of an asset or liability changing. Changes in value are reported in earnings.

Question 17

What is a Cash Flow Hedge?

Answer 17

A hedge that protects against a set of future cash flows changing. Changes in value are reported in OCI.

Question 18

What is a Foreign Currency Hedge?

Answer 18

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.