Financial Risk Management Flashcards
(38 cards)
1
Q
Define risk
A
- the chance of financial loss
- may be used interchangeably with the term “uncertainty” to refer to the variability of returns associated with a given asset
2
Q
Define return
A
- the total gain or loss experienced on behalf of the owner of an asset over a given period
- greater risk yields greater returns
3
Q
What are the 3 basic risk preference behaviors that exist?
A
- Risk indifferent behavior- an increase in risk does not result in an increase in return; this is an exception since it is unusual
- Risk averse behavior- an increase in risk results in an increase in return; managers require higher expected returns to compensate for greater risk; general rule
- Risk seeking behavior- an increase in risk results in a decrease in return; managers are willing to settle for lower expected returns as risk increases; this is an exception since it is very rare
4
Q
Define default risk and how to mitigate it
A
- affects lenders (investors)
- creditors are exposed to default risk to the extent that it is possible that its debtors may not repay the principal or interest due on their indebtedness on a timely basis
- mitigation: lend only to borrowers with low risk of default; adjust the interest rates charged to better reflect the risk of each borrower (high risk borrowers pay higher interest rates)
5
Q
Define liquidity risk and how to mitigate it
A
- affects lenders (investors)
- when lenders want to sell their security but cant do so in a timely manner or when material price concessions have to be made to do so
- mitigation: allocate a greater percentage of capital to investments that trade on active markets such as equities, corporate bonds, futures contracts and options
6
Q
Define price risk and how to mitigate it
A
- 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 price risk which becomes an even greater concern with increased market volatility
- related to diversifiable (unsystematic) risk
- mitigation: diversification, short selling or derivatives like put options
7
Q
What is the stated interest rate?
A
- represents the rate of interest charged before any adjustment for compounding or market factors (sometimes referred to as nominal interest rate)
- shown in the agreement of indebtedness (bond indenture or promissory note)
8
Q
What is the annual percentage rate?
A
- represents a noncompounded version of the effective annual percentage rate
- the rate required for disclosure by federal regulations
- computed as the effective periodic interest rate * # of periods in a year
- emphasizes the amount paid relative to funds available
9
Q
What is the effective annual percentage rate?
A
- represents the stated interest rate adjusted for the number of compounding periods per year
- abbreviated APR
= [1+ (i/p)]^p -1
i= stated interest rate
p= compounding periods per year
10
Q
What is simple interest?
A
- the amount represented by interest paid only on the original amount of principal without regard to compounding
SI= Po (i)(n)
Po= original principal
i= interest rate per time period
n= number of time periods
11
Q
What is compound interest?
A
- the amount represented by interest earnings or expense that is based on the original principal plus any unpaid interest earnings or expense
- interest earnings or expense compounds and yields an amount higher than simple interest
FVn= Po (1+i)^n
P0= original principal
i= interest rate
n= number of periods
12
Q
How is the required rate of return calculated?
A
risk premium + risk free rate
13
Q
What is the Maturity Risk Premium (used to compute the required rate of return)?
A
- the compensation that investors demand for exposure to interest rate risk over time
- this risk increases with the term to maturity
14
Q
What is the Inflation Premium/ Purchasing Power Risk (used to compute the required rate of return)?
A
- the compensation investors require to bear the risk that price levels will change and affect asset values or the purchasing power of invested dollars (ex: real estate)
15
Q
What is the Liquidity Risk Premium (used to compute the required rate of return)?
A
- the additional compensation demanded by lenders for the risk that an investment security (ex: junk bonds) cannot be sold on a short notice without making significant price concessions
- liquidity= the ability to quickly convert an asset to cash at FMV
16
Q
What is the Default Risk Premium (used to compute the required rate of return)?
A
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
17
Q
How is the nominal rate of return calculated?
A
real rate of return + inflation premium
18
Q
What is short selling?
A
selling an investment in the hopes of buying it back at a lower price later
19
Q
Describe the relative inflation rate trade factor that influences exchange rates
A
- when domestic inflation > foreign inflation, holders of domestic currency are motivated to purchase foreign currency to maintain the purchasing power of their $$
- the increase in demand for foreign currency forces the value of the foreign currency to rise in relation to the domestic currency, chanign the exchange rate
20
Q
Describe the relative income levels trade factor that influences exchange rates
A
as income increases in one country relative to another, exchange rates change as a result of increased demand for foreign currencies in the country in which income is increasing
21
Q
Describe the government controls trade factor that influences exchange rates
A
various trade and exchange barriers that artificially supress the natural forces of supply and demand affect exchange rates
22
Q
Describe the relative interest rates and capital flows financial factor that influences exchange rates
A
- interest rates create demand for currencies by motivating either domestic or foreign investments
- the forces of supply and demand create changes in the exchange rates as investors seek fixed returns
- the effect of interest rates is directly affected by the volume of capital that is allowed to flow between countries
23
Q
What is transaction exposure?
A
- the potential that an org could suffer economic loss or experience economic gain upon settlement of individual transactions as a result of changes in the exchange rates
- measured in relation to currency variability or currency correlation
- measured in 2 steps: 1. project foreign currency inflows and outflows 2. estimate the variability (risk) associated with the foreign currency
24
Q
What is economic exposure?
A
- the potential that the present value of an organization’s cash flows could increase or decrease as a result of changes in the exchange rates
- defined through local currency appreciation or depreciation and measured in relation to organization earnings and cash flows
25
Define currency appreciation and its effect
- the strengthening of a currency in relation to other currencies
- as domestic currency appreciates in value, it becomes more expensive in terms of a foreign currency
- as a currency appreciates, the volume of outflows tends to decline as domestic exports become more expensive
- the volume of inflows tends to increase as foreign imports become less expensive
26
Define currency depreciation and its effect
- the weakening of a currency in relation to other currencies
- as a domestic currency depreciates in value, it becomes less expensive in terms of a foreign currency
- as a currency depreciates, the volume of outflows rises as domestic exports become less expensive
- the volume of inflows tends to decline as foreign imports become more expensive
27
Define translation exposure
- the risk that assets, liabilities, equity or income of a consolidated org that includes foreign subsids will change as a result of changes in exchange rates
- defined by the degree of foreign involvement, the location of foreign subsids and the acctg methods used and measured in relation to the effect on the org's earnings
- exposure increases as the proportion of foreign involvement by subsids increases
- the more stable the exchange rate, the lower the translation risk and vice versa
28
What is hedging?
- a financial risk mgmt technique in which an org, seeking to mitigate the risk of fluctuations in value, acquires a financial instrument that behaves in the opposite manner from the hedged item
- a process of reducing the uncertainty of the future value of a transaction or position by actively engaging in various derivative instruments
- mitigates transaction exposure
29
What is net transaction exposure?
the amount of gain or loss that might result from either a favorable or an unfavorable settlement of a transaction
30
Describe a futures hedge
- entitles its holder to either purchase or sell a particular number of currency units of an identified currency for a negotiated price on a stated date
31
Describe the futures hedge AP application
- AP denominated in a foreign currency represents a potential transaction exposure to echange rate risk in the event that the domestic currency weakens in relation to the foreign currency
- should the DC weaken relative to the FC, more DC will be required to purchase the FC, increasing the company's cost of settling the liability
- if mgmt does not hedge this liability exposure, the co will incur a foreign exchange transaction loss
- a futures hedge contract to buy the foreign currency at a specific price at the time the account payable is due will mitigate the risk of a weakening domestic currency
32
Describe the futures hedge AR application
- AR denominated in a foreign currency represents a potential transaction exposure to xchange rate risk in the event that the DC strengthens in relation to the FC
- should the DC strengthen, less DC can be purchased with the FC received, resulting in a loss
- a futures hedge contract to sell the FC received in satisfaction of the receivable at a specific price at the time the AR is due will mitigate the risk of a strengthening DC
33
Describe a forward hedge
- entitles its holder to either purchase or sell currency units of an identified currency for a negotiated price at a future point
- contracts between businesses and commercial banks and are larger transactions
- anticipates a company's needs to either buy or sell a FC at a particular point
34
Describe the forward hedge AP application
- AP denominated in a FC represent a potential transaction exposure to exchane rate risk in the event that the FC strengthens
- a forward hedge contract to buy the FC at a specific price at the time AP are due for an entire subsid will mitigate the risk of a weakening DC
35
Describe the forward hedge AR application
- AR denominated in a FC represent a potential transaction exposure to exchange rate risk in the event that the DC strengthens
- a forward hedge contract to sell the FC received in satisfaction of the receivables at a specific price at the time the AR are due or on a monthly cycle of a particular subsid will mitigate the risk of a strengthening DC
36
What is a money market hedge?
- uses international money markets to plan to meet future currency requirements
- uses DC to purchase a FC at current spot rates and invest them in securities timed to mature at the same time as related payables
37
What is a currency option hedge?
gives the business the option of executing the option contract or purely settling its originally negotiated transaction without the benefit of the hedge, depending on which result is most favorable
38
What are long term forward contracts?
- set up to stabilize transaction exposure over long periods
- may be hedged with long term purchase contracts
