Risk Management

Question 1

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Define Market Risk

Answer 1

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

Question 2

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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

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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

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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

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What does Standard Deviation measure?

Answer 5

It measures the volatility of an investment.

Question 6

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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

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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

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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

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What is Variance?

Answer 9

It compares volatility of an investment to the market average.

Factors include both Systematic and Unsystematic Risk.

Question 10

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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

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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

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What is a Future?

Answer 12

A Forward Contract with a future value.

They are sold and traded on the futures market.

Question 13

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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

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What is Legal Risk?

Answer 14

Risk that a law or regulation will void the derivative

Question 15

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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

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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

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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.