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Define Market Risk
The risk that a sluggish economy will affect the value of a debt instrument
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Define Sector Risk
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
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Define Credit/Default Risk
The risk that a debtor will be unable to make loan payments or pay back the principal
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Define Interest Rate Risk
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.
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What does Standard Deviation measure?
It measures the volatility of an investment.
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What is Systematic Risk?
Risk that impacts the entire market and can’t be avoided or reduced through diversification
Example: Wars
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What is Unsystematic Risk?
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
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What does Beta measure?
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?
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What is Variance?
It compares volatility of an investment to the market average.
Factors include both Systematic and Unsystematic Risk.
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What is a Derivative?
An asset whose value is DERIVED from the value of another asset.
Derivatives are measured at Fair Value.
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How is an Option used?
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
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What is a Future?
A Forward Contract with a future value.
They are sold and traded on the futures market.
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What is an Interest Rate Swap?
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
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What is Legal Risk?
Risk that a law or regulation will void the derivative
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What is a Fair Value Hedge?
Hedge that protects against the value of an asset or liability changing.
Changes in value are reported in earnings.
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What is a Cash Flow Hedge?
A hedge that protects against a set of future cash flows changing.
Changes in value are reported in OCI.
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What is a Foreign Currency Hedge?
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.
