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

The Treynor index is based on the premise that there are two components of risk

Answer 18

1. Risk produced by fluctuations in the market

2. Risk produced by fluctuations of the individual stock

Question 19

The drum-buffer-rope theory

Answer 19

• Assumes that within a manufacturing system there is at least one (or a limited number) of constraints created by scarce resources.
• States that in order to best protect the throughput of a manufacturing operation, the limiting factor of the manufacturing process must be protected.
• States that it is important to protect against inflationary inventory levels (inventory build ups) and the associated carrying costs which can occur at bottlenecks (constraints).
• Focuses on only the queuing area within a manufacturing firm that is in front of the constraint (bottleneck).

Question 20

What is Kanban technique

Answer 20

is a technique for managing a just-in-time inventory system. The kanban is a tag attached to the storage container where component parts are kept. As a component is used, a kanban is placed in a box. Managers determine the number of kanbans needed to be in the box of the component part before a reorder of that part is necessary.

Question 21

weak-form market efficiency

Answer 21

suggests that information about past prices would not be of use in predicting future performance

Question 22

semi-strong market efficiency

Answer 22

suggest that all publicly available information is incorporated in market prices

Question 23

strong-form efficient markets

Answer 23

suggest that all available information is incorporated in current market prices

Question 24

What is a failed-soft protection?

Answer 24

It is an advantage of distributed systems.

Allows for the capability to continue processing at all sites except a nonfunctioning one

Question 25

Poison put clause

Answer 25

It is a covenant that obliges the borrower to repay the bonds if a large quantity of common stock is held by a single investor and the bond rating is downgraded. This type of bond covenant is used as a defensive strategy to prevent hostile takeovers.

Question 26

Certainty equivalent adjustments

Answer 26

is a risk analysis technique that is based upon utility theory. The “utility” is how much a certain sum of money is worth to the investor. It makes the decision maker stipulate at what point he or she is indifferent to the choice between a certain amount of money and the expected value of a risky amount.