Financial Risk Management Pt. 1

Question 1

Risk and return are a function of both market conditions and the risk preferences of the parties involved

Answer 1

risk - the chance of financial loss

return - the total gain/loss experienced on behalf of the owner of an asset over a given period (typically, greater risk yield = greater return)

Question 2

What are the 3 different risk preference behaviors?

Answer 2

risk-indifferent: reflects an attitude toward risk in which an increase in the level of risk does not result in an increase in management’s required rate of return

risk-averse: reflects an attitude toward risk in which an increase in the level of risk results in an increase in management’s required rate of return; this requires higher expected returns to compensate for greater risk (most managers fall in this category)

risk-seeking: reflects an attitude toward risk in which an increase in the level of risk results in a decrease in management’s required rate of return; willing to settle for lower expected returns as the level of risk increases

Question 3

What is interest rate risk (or yield risk)?

Answer 3

represents the exposure of the owner of the instrument to fluctuations in the value of the instrument in response to changes in interest rates

Question 4

What is market/systematic/nondiversifiable risk?

Answer 4

the exposure of a company to fluctuations in value as a result of operating within an economy; it is a risk inherent in operating within the economy (related to factors such as war, inflation, international incidents, political events)

Question 5

What is unsystematic/firm-specific/diversifiable risk?

Answer 5

represents the portion of a company’s risk that is associated with random causes and can be eliminated through diversification; it is attributable to industry-specific events (strikes, lawsuits, regulatory actions, loss of a key account)

Question 6

What is credit risk?

Answer 6

it affects borrowers; as credit ratings decline, the interest rate demanded by lenders increases with other terms being generally less favorable to the borrower including the potential of collateral being required

Question 7

What is default risk?

Answer 7

it affects lenders; this is when debtors may not repay the principal or interest due on their indebtedness on a timely basis

Question 8

What is liquidity risk?

Answer 8

if affects lenders; this is when they desire to sell their security but cannot do so in a timely manner or when material price concessions have to be made to do so

Question 9

What is price risk?

Answer 9

represents the exposure that investors have to a decline in the value of their individual securities or portfolios; factors unique to individual investments and/or portfolios contribute to this which becomes an even greater concern with increased market volatility (related to unsystematic risk)

Question 10

What is stated interest rate (aka nominal rate)?

Answer 10

represents the rate of interest charged before any adjustment for compounding or market factors

computation: it is the rate shown in the agreement of indebtedness

Question 11

What is effective interest rate?

Answer 11

represents the actual finance charge associated with a borrowing after reducing loan proceeds for charges and fees related to a loan origination

computation: dividing the amount of interest paid based on the loan agreement by the net proceeds received

Question 12

What is annual percentage rate?

Answer 12

represents a non-compounded version of the effective annual percentage rate; the annual percentage rate is the rate required for disclosure by federal regulations

computation: the effective periodic interest rate times the number of periods in a year; annual percentage rate emphasizes the amount paid relative to funds available

Question 13

What is effective annual percentage rate?

Answer 13

represents the stated interest rate adjusted for the number of compounding periods per year (abbreviated APR)

computation: effective annual interest rate = [1 + (stated interest rate / compounding periods per year)]^compounding periods per year - 1

^ = shows item after it is an exponent

Question 14

What is simple interest (amount)?

Answer 14

represented by interest paid only on the original amount of principal without regard to compounding

computation: simple interest = original principal * (interest rate per time period) * (number of time periods)

Question 15

What is compound interest (amount)?

Answer 15

represented by interest earnings or expense that is based on the original principal plus any unpaid interest earnings or expense

computation: future value = original principal (1 + interest rate)^number of periods

^ = shows item after it is an exponent

Question 16

The required rate of return is calculated by adding the following risk premiums to the risk-free rate:

Answer 16

maturity risk premium (MRP) - the compensation that investors demand for exposure to interest rate risk over time; the risk increases with the term to maturity

purchasing power risk or inflation premium (IP) - the compensation investors require to bear the risk that price levels will change and affect asset values or the purchasing power of invested dollars

liquidity risk premium (LP) - the additional compensation demanded by lenders for the risk that an investment security cannot be sold on a short notice without making significant price concessions; liquidity is defined as the ability to quickly convert an asset to cash at FMV

default risk premium (DRP) - the additional compensation demanded by lenders for bearing the risk that the issuer of the security will fail to pay interest and/or principal due on a timely basis

Question 17

What is diversifiable risk?

Answer 17

represents the portion of a single asset’s risk that is associated with random causes and can be eliminated through diversification

Question 18

How can an investor mitigate interest rate risk?

Answer 18

by investing in floating rate debt securities which do not change in value when interest rates change and also generate higher coupon payments when interest rates rise

Question 19

How can an investor mitigate market risk?

Answer 19

because it is inherent in the marketplace and overall economy, it isn’t easy to mitigate; market risk cannot be mitigated through diversification; one way to control it is to invest in derivatives that provide gains to the investor when the market declines; short selling is another strategy that provides returns when the market declines

Question 20

How can an investor mitigate unsystematic risk?

Answer 20

it can be minimized through diversification; a negative effect on one firm/industry/investment would have less of an effect on the value of the portfolio as a whole

Question 21

How can an investor mitigate credit risk?

Answer 21

it can be managed through improvements in credit ratings; when credit ratings are higher, borrowing can occur at more favorable terms

Question 22

How can an investor mitigate default risk?

Answer 22

it can be done several ways; one way is for a lender to lend only to borrowers with low risk of default; another option is to adjust the interest rates charged to better reflect the risk of each borrower so that higher risk borrowers will pay higher interest rates

Question 23

How can an investor mitigate liquidity risk?

Answer 23

this is higher for investments that don’t have active markets; it can be mitigated by allocating a greater percentage of capital to investments that trade on active markets

Question 24

How can an investor mitigate price risk?

Answer 24

it can be minimized through diversification; it can also be mitigated through short selling or derivatives such as put options (it gives its owner the right to sell a specific security at fixed conditions of price and time)