Flashcards in financial risk Deck (71):
What is a return?
The amount received by an investor as compensation for taking on the risk of the investment.
Rate of Investment (ROI) formula
Return on investement : Amount received - Amount invested
What is rate of return?
The return stated as a percentage of the amount invested
Rate of Return (ROR) formula
Rate of return : Return on investment / amount invested
Two basic types of investment risk
1. Systematic Risk (aka Market Risk)
2. Unsystematic Risk (aka Unique Risk)
What is Systematic Risk?
The risk faced by all firms.
Changes in the economy as a whole, such as inflation or the business cycle, affect all players
Systematic Risk is also referred to as?
Undiversifiable Risk, since all investments are affected this risk cannot be offset through diversification.
What is Unsystematic Risk?
The risk inherent in a particular investment. In other words the risk of a specific company
Determined by the firm's industry, products, customer loyalty, degree of leverage, mgmt competence, etc.
Unsystematic Risk is also referred to as:
Diversifiable risk, since individual investments are affected by the particular strengths and waekness of the firm, this risk can be offset through diversification.
What is Credit default risk?
The risk that the borrower will default and will not be able to repay the principal or interest that it is obligated to pay.
This risk can be gauged by the use of credit-rating agencies.
What is Liquidity risk?
The risk that a security cannot be sold on short notice for its market value.
What is Maturity risk?
aka: Interest rate risk
The risk that an investment security will fluctuate in value between the time it was issued and its maturity date.
The longer the time until maturity, the greater the degree of maturity risk.
What is Inflation risk?
The risk that purchasing power will be lost while the loan is at the borrower's disposal.
What is Political risk?
The probability of loss from actions of governments, such as from changes in tax laws or environmental refulations or from expropriation of assets.
What is Exchange rate risk?
The risk of loss because of fluctuation in the relative value of foreign currency.
What is Business risk?
aka: Operations risk
The risk of fluctuations in earnings before interst and taxes or in operating income when the firm uses not debt.
What factors does business risk depend on?
Factors such as Demand variability, sales price variability, input price variability, and amount of operating leverage.
What is country risk?
The overall risk of investing in a foreign country.
What is Principal risk?
The risk of losing the amount invested, ie., the principal.
What is Risk Averse?
The utility of a gain does not outweigh the disutility of a potential loss of the same amount.
What is Risk-Neutral?
The investor adopts an expected value approach because (s)he regards the utility of a gain as equal to the disutility of a loss of the same amount.
What is Risk-Seeking?
The investor has an optimistic attitude
What is Risk Premium?
The excess of an investment's expected rate of return over the risk-free interest rate.
What is the Risk-Free rate?
The interst rate on the safest investment.
Stated interest rate on US Treasury bills is considered to be the risk-free interest rate.
What is the Required Rate of Return?
The return that takes into account all the investment risks that relate to a specific security.
What is Financial Risk?
The risk to the shareholders from the use of financial leverage.
What is the relationship between the safety of an investment and its potential return?
A method for mathematically expressing doubt or assurance about the occurrence of a chance event.
The set of all possible outcomes of a decision, with a probability assigned to each outcome.
Expected rate of return (?)
An average of the possible outcomes weighted according to their probabilities
Formula for expected rate of return
Expected rate of return : Sum(possible rate of return x probability)
What is Risk?
The chance that the actual return on investment will differ from the expected return.
What is Standard Deviation and what does it measure?
Measures the tightness of the distribution and the riskiness of the investment.
Formula for Standard Deviation
Standard deviation : Square root of Sum [(Possible rate of return - Expected rate of return)squared x probability] : Square root of Variance
The greater the standard deviation the ______ the investment.
The coefficient of variation (CV)
Measures the 'Risk per unit of return'. It is useful when the rates of return and standard deviations of two investments differ.
Coefficient of variation (CV) formula:
Coefficient of variation : Standard deviation / expected rate of return
The lower the CV ratio, ____________
The better the risk-return tradeoff is.
What is diversification?
A basket of securities that generates a reasonable rate of return without the risks associated with holding a single security
What are specific risk associated with a single investment security?
What is the coefficient of correlation (r)?
Measures the degree to which any 2 variables, eg the prices of 2 stocks, are related.
What is perfect positive correlation?
(1.0) Means that the 2 variable always move together
What is perfect negative correlation?
(-1.0) Means that the 2 variables always move in the opposite direction.
Captial asset pricing model (CAPM)
The measure of how a particular security contributes to the risk and return of a diversified portfolio.
The CAPM formula is based on the idea that the investor must be compensated for his/her investment in what 2 ways?
Time value of money and Risk
The market risk premium is:
the return provided by the market over and above the risk-free rate, weighted by beta
what is beta? ?
The measure of a security's risk.
Market Risk Premium formula
market return - risk-free rate
What is Security risk premium?
The required rate of return of the security is the risk-free rate of return plus the security risk premium.
Security risk premium formula
Beta(Market return - risk-free rate)
What is a derivative instrument?
An investment transaction in which the parties' gain or loss is derived from some other economic event, for example, the price of a given stock, a foreign currency exchange rate, or the price of a certain commodity.
In a derivative transaction one party enters the transaction to _________ and the other enters into it to _________.
speculate (incur risk); hedge (avoid risk)
what is hedging?
The process of using offsetting commitments to minimize or avoid the impact of adverse price movements.
The entity takes a position in a financial instrument that is almost perfectly correlated with the original asset but in the opposite direction.
Whenever the entity owns the asset. An entity with a long position therefore benefits from a rise in the asset's value.
When the entity sells an asset that it does not own at the time of the sale. Entities take short positions when they believe the value of the asset will decrease.
Gives the buyer (holder) the right to purchase (ie the right to "call" for) the underlying asset (stock, currency, commodity, etc.) at a fixed price.
Gives the buyer (holder) the right to sell (ie the right to "put" onto the market) the underlying asset (stock, currency, commodity, etc.) at a fixed price.
The asset that is subject to being bought or sold under the terms of the option.
The party buying an option
The seller of the option
The price at which the holder can purchase (in the case of a call option) or sell (in the case of a put option) the underlying asset in the option contract.
An increase in the exercise price of an option results in a decrease in the value of a call option and an increase in the value of a put option.
Price of underlying
The price of the underlying increases, the value of a call option also will increase; the exercise price is more and more of a bargain with each additional dollar in the price of the underlying
Time until expiration
The longer the term of an option, the greater the chance that the underlying price will change and the option will be in-the-money.
An increase in the term of an option (both calls and puts) will result in lan increase in the value of the option.
Volatility of Price of underlying
Since the holder's loss of an option is limited to the option premium (amount paid for the option), the holder prefers greater volatility of the underlying price the more volatile the price of the underlying, the greater the chance that the underlying price will change and the option will be in-the-money. An increase in the volatility of the price of the underlying will result in an increase in the value of the option (both calls and puts).
Intrinsic value of a call option
The amount by which the exercise price is less than the current price of the underlying.
If an option has a positive intrinsic value
If an option has an intrinsic value of $0
Intrinsic value of a put option
The amount by which the exercise price is greater than the current price of the underlying
Two parties agree that, at a set future date, one of them will perform and the other will pay a specified amount for the performance.
Note the significant difference between a forward contract and an option: In a contract, both parties must meet their contractual obligation, ie, to deliver merchandise and to pay. Neither has the option of nonperformance.
Forward contract are heavily used in foreign currency exchange.
A commitment to buy or sell an asset at a fixed price during a specific future period; unlike with a forward contract, the counterparty is unknown.
Futures contracts are actively traded on futures exchanges. The clearing house randomly matches sellers who will deliver during a given period with guyers who are seeking delivery during the same period.