Finance & Risk 1&2 Flashcards
(10 cards)
What is the core definition of finance?
The trade in risks across time.
Define a contingent cashflow.
A schedule of payments c(t, ω) at times t in states ω.
What makes a cashflow an asset or a liability?
If c(t,ω) ≥ 0 for all t,ω it’s an asset; if c(t,ω) ≤ 0, it’s a liability.
What is the present value (PV) of a payoff π at rate r?
PV = π / (1 + r).
How do you calculate the discount factor for k periods?
D_k = 1 / (1 + r)^k.
What is arbitrage?
A risk-free profit from mispriced identical cashflows.
State the Law of One Price.
Identical contingent cashflows must have the same price, or arbitrage exists.
What is a risk premium?
The spread s = R - r, the extra return for a risky cashflow over the risk-free rate.
Give an example of arbitrage with lending and borrowing rates.
Borrow at r and lend at R > r to earn a risk-free profit of (R - r) per unit.
Why do contingent cashflows create risk?
Because the future state ω is uncertain, making cashflows random variables.
