FM W2

Question 1

what is risk

Answer 1

the measure of uncertainty about the future payoff to an investment, assessed over some time horizon, relative to a benchmark

Question 2

what is the expected value

Answer 2

the mean = sum of probabilities multiplied by their payoffs

Question 3

what is a risk-free asset

Answer 3

an asset whose return is the risk free rate of return

Question 4

what is the value at risk

Answer 4

the worst possible loss over a specific horizon at a given probability

Question 5

what effect does a riskier investment have on the risk premium

Answer 5

increase risk = increase risk premium

Question 6

what are the two main types of risk

Answer 6

1. Affecting a fewer number of people - idiosyncratic and diversifiable.
2. Those affecting everyone - systematic and undiversifiable.

Question 7

2 types of idiosyncratic risk

Answer 7

1. Bad for one sector of the economy, but good for another.
2. Unique risk specific to one person or one company and no one else.

Question 8

what is hedging

Answer 8

a way of reducing idiosyncratic risk by making 2 investments with opposing risk to eliminate the risk

Question 9

what is spreading

Answer 9

reducing idiosyncratic risk by making 2 investments that are unrelated

Question 10

what is the bond supply curve

Answer 10

the relationship between the price and the quantity of the bonds people are willing to sell, all else being equal

Question 11

what is the bond demand curve

Answer 11

the relationship between the price and the quantity of the bonds that investors demand, all else being equal

Question 12

what affects bond supply

Answer 12

1. increase gov borrowing = increase supply.
2. improved business conditions = increase supply.
3. increased expected inflation = reduced cost of borrowing = increased supply.

Question 13

what affects bond demand

Answer 13

1. increase wealth = increase demand.
2. increase expected inflation = decrease demand.
3. increase interest rates = decrease demand.
4. increased liquidity = increase demand

Question 14

why are bonds risky

Answer 14

1. Default risk - the bond’s issuer fails to make the promised payment.
2. Inflation risk - investors cannot be sure of what the real value of payments will be.
3. Interest-rate risk - investors don’t know the holding period return of a long-term bond.

Question 15

what is the risk premium

Answer 15

the spread between the interest rates on bonds with default risk and the interest rates on treasury bonds.

Question 16

what are speculative grade bonds

Answer 16

bonds issued by companies and countries who may have problems meeting their bond payments but are not at risk of immediate default.

Question 17

what are junk bonds

Answer 17

bonds that have grades below investment grade

Question 18

The yield on a taxable bond issue after income taxes are paid is equal to…

Answer 18

Tax-Exempt Bond Yield = (Taxable Bond Yield) x (1 - Tax Rate)

Question 19

The yield that must be offered on a taxable bond issue to give the same after-tax yield as a tax-exempt issue is equal to…

Answer 19

Equivalent-Taxable Yield = (Tax-Exempt Yield) / (1 - Tax Rate)