Risk Management B6

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

Credit Risk: (affect borrower) Company unable to get loan or get a loan on high unfavorable interest rate
Default Risk: (affect lender) 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, Inflation

DUNS
Nondiversifiable Risk
Systematic, market factor

Question 7

What is Unsystematic Risk?

Answer 7

Relates to a particular industry or company; firm specific risk

Example: Strike; You own stocks in ethanol plants and an untimely freeze kills all of the corn in the Midwest

DUNS
Diversifiable Risk (Unique risk)
Unsystematic, nonmarket factor, firm specific

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.

FC up, A/P up
  -buy forward or futures hedge
  -buy call
FC down, A/R down
  -sell forward of futures hedge
  -buy put

Question 18

What is the Effective Interest Rate?

Answer 18

The effective interest rate represents the actual finance charge net fees on loan.

Effective Periodic Interest Rate:
Interest paid (principle X stated nominal rate X # periods)
Divide by: (principle less fees)

Question 19

What is the Annual Percentage Rate?

Answer 19

The annual percentage rate (APR) represents a noncompounded version of effective interest rate

APR= Effective interest rate X # periods
and/or
APR= annual interest paid / net proceeds

Question 20

What is the Effective Annual Percentage Rate?

Answer 20

The effective annual percentage rate represents the state interest rate adjusted for number of compound periods per year.

Effective annual % rate =
[(1+effective periodic rate)^ # compounds ] -1

Question 21

What is Simple Interest?

Answer 21

Interest paid only on the original principle

Principle X annual rate X # years

Question 22

What is Compound Interest?

Answer 22

Interest on original principle plus unpaid interest

```
think Raise
Compound interest=
principle X (1+ interest rate)^ # years
~~~