Flashcards in Module 43a: Financial Risk Management Deck (77):

1

## there is a trade off between risk and returns when considering investments

### to achieve higher returns an investor must assume greater risk

2

## variance is the term used for

### higher risk

3

## equity risk premium

###
equal to the real return on stocks minus the risk-free real return as measured by the treasury bills

chart on page 192

4

## average risk premium on common stock versus bonds over the ten year period (page 192)

### is mean return on stocks minus mean return on bonds

5

## risk averse

###
most financial models assume that investors are risk averse

risk aversion does not mean investors will not take risks; it means that they must be compensated for taking a risk

most investors and the market as a whole are considered by most analysts to be risk averse

however, certain investors may exhibit different behavior

6

## risk neutral investors

###
investors that prefer investments with higher returns whether or not they have risk

these investors disregard risk

7

## risk seeking investors

### investors that prefer to take risks and would invest in a higher risk investment despite the fact that a lower risk investment might have the same return

8

## investment return

###
the total gain or loss on an investment for a period of time

consists of the change in the asset's value (either gain or loss) plus any cash distribution (cash flow, interest, dividends)

9

## ex post basis

###
"after the fact" investment return formula

therefore it does not consider risk

10

## ex ante basis

### managers have to evaluate investments on an ex ante basis and therefore must use expexted returns and estimates of risk

11

## estimating expected returns

###
a common way to do this is based on prior history

one could simply calculate the average historical returns on a similar investment to get the expected return

two approaches are often used in making this computation:

1. arithmetic average return

2. geometric average return

12

## arithmetic average return

###
computed by simply adding the historical returns for a number of periods and dividing by the number of periods

generally recommended that arithmetic average be used for assets with short holding periods (vs longer holding periods)

13

## geometric average return

###
this computation depicts the compound annual return earned by an investor who bought the asset and held it for the number of historical periods examined

if returns vary through time, the geometric average will always fall below the arithmetic average

it is recommended that geometric average be used for assets with longer holder periods (vs short holding periods)

14

## estimating risk

###
measures of risk are often developed from historical returns

the pattern of historical returns of large numbers of similar investments approximates a nomal distribution (bell shaped curve) with the mean being the expected return and the variance, or standard deviation, measuring the dispersion around the expected return

**if you assume that the distribution is normal, about 95% of the returns will fall within the range created by expected return plus/minus two standard deviations

15

## coefficient of variation

###
a measurement of risk, where a lower number is less risky (the higher the number the riskier)

=standard deviation/expected return

16

## when an investor invests in a portfolio of assets, the expected returns are simply

###
the weighted average of the expected returns of the assets making up the portfolio

Expected return on the portfolio= (the weight of asset1)(expected return on asset1) + etc of 2

17

## the variance of portfolio returns

###
depends on three factors:

1. the percentage of the portfolio invested in each asset (the weight)

2. the variance of the returns of each individual asset

3. the covariance among the returns of assets in the portfolio

18

## Covariance

###
the covariance captures the degree to which the asset returns move together over time

if returns on the individual assets move together, there is little benefit to holding the portoflio

on the other hand, if returns on some assets in the portfolio go up when returns on other assets in the portfolio go down, holding the portfolio reduces overall risk

19

## portfolios allow investors to diversify away unsystematic risk

###
unsystematic risk= the risk that exists for one particular ivnestment or a group of like investments (e.g. technology stock)

by having a balanced portfolio, investors can theoretically eliminate this risk

20

## systematic risk

###
relates to the market factors that cannot be diversified away

all investments are to some degree affected by them

examples: fluctuations in GDP, inflation, interest rates, etc.

21

## beta

###
it measures how the value of a particular investment moves along with the market (chanes in the value of the portfolio)

it can be used to evaluate the effect of an individual investments risk on the risk of the entire portfolio

22

## risk preference function

###
an individual investor has a risk preference function, which describes the investor's trade-off between risk and return

a portfolio that falls on the line described by this function is an efficient portfolio

23

## interest rates

### represent the cost of borrowing funds

24

## credit or default risk

###
the risk that th firm will default on payment of interest or principal of the loan or bond

this may be divided into two parts:

1. the individual firm's creditworthiness (or risk of default) and

2. sector risk- the risk related to economic conditions in the firm's economic sector

credit risk is an example of unsystematic risk that you can diversify away

credit risk can be eliminated by diversification (investing in a portfolio of loans or bonds)

25

## interest rate risk

###
the risk that the value of the loan or bond will decline due to an increase in interest rates

part of systematic risk that must be accepted by the investor

something with risk payment that is fixed- if interest rate goes up, since yours is valued at a fixed investment, the value of yours is going to go down

26

## market risk

###
the risk that the value of a loan or bond will decline due to a decline in the aggregate value of all the assets in the economy

part of systematic risk that must be accepted by the investor

recession or depression

27

## business risk

###
in determining the appropriate interest rate to accept, investors and creditors consider the business risks of the loan or investment

relevant business risks are:

1. credit or default risk

2. interest rate risk

3. market risk

28

## in order to put interest rates on a common basis for comparison,

### management must distinguish between the stated interest rate and the effective annual interest rate

29

## stated interest rate

### the contractual rate charged by the lender

30

## effective annual interest rate

###
the true annual return to the lender

the simple annual rate may vary from the effective annual rate because interest is often compounded more often than annually

31

## the term structure of interest rates

###
describes the relationship between long and short term raes

these relationships are important in determining whether to use long-term fixed or variable rate financing

a yield curve is used to illustrate the relative level of short term and long term interest rates at a point in time

possible yield forms:

1. normal yield curve

2. inverted (abnormal) yield curve

3. flat yield curve

4. humped yield curve

page 195

32

## normal yield curve

###
an upward sloping curve in which short term rates are less than intermediate-term rates which are less than long term rates

ST < IR < LT

33

## inverted (abnormal)yield curve

###
a downward sloping curve in whcih short term rates are greater than intermediate term rates which are greater than long term rates

ST > IR > LT

34

## flat yield curve

###
a curce in which short term, intermediate term, and long term rates are all about the same

ST = IR = LT

35

## humped yield curve

###
a curve in which intermediate term rates are higher than both short term and long term rates

IR > ST & LT

36

## maturity risk premiums

### required for long-term lending because long-term rates are usually higher because they involve more risk (as described in the normal yield curve)

37

## theories that attempt to explain the yield curve

###
1. liquidity preference (premium) theory

2. market segmentation theory

3 expectations theory

38

## liquidity preference (premium) theory

###
states that long-term rates should be higher than short-term rates because investors have to be offered a premium to entice them to hold less liquid and more price-sensitive securities

remember: if an investor holds a fixed rate long-term security and interest rates increase, the value of the security will decline

39

## market segmentation theory

###
states that treasury securities are divided into market segments by the various financial institutions investing in the market

commercial banks prefer short-term securities to match their short-term lending strategies

savings and loans prefer intermediate-term securities

life insurance companies prefer long-term securities because of the nature of their commitments to policyholders

the demand for various term securities is therefore dependent on the demands of these segmented groups of investors

40

## expectations theory

###
explains yields on long-term securities as a function of short-term rates

specifically, it states that long-term rates reflect the average short-term expected rates over the time period that the long-term security will be outstanding

under this theory, long-term rates tell us about market expectations of short-term rates

if long-term rates are lower than short term rates, the market is expecting short term rates to fall and the market is indicating that inflation wil decline

41

## all interest rate theories make it difficult to predict interest rates in general therefore,

### sound financial policy calls for using a combination of long term and short term debt and equity to enable the firm to survive at any interest rate environment

42

## the mix of long term and short term debt affect a firms financial statements....

###
a heavy reliance on short term or variable rate debt means that interest expense and therefore net income will be more variable

this increases the financial risk of the firm and will cause creditors and investors to demand higher rates to compensate for the increased risk

43

## derivative

###
a financial instrument or contract whose value is derived from some other financial measure (underlyings, such as commodity prices, stock prices, interest rates) and includes payment provisions

common examples of derivatives:

1. options

2. forwards

3. futures

4. currency swaps

5. interest rate swaps

6. swaption

44

## options

### allow but do not rewuire the holder to buy (call) or sell (put) a specific or standard commodity or financial instrument, at a specified price during a specified period of time (american option) or at a specified date (european option)

45

## forwards

###
negotiated contracts to purchase and sell a specific quantity of a financial instrument, foreign currency, or commodity at a price specified at origination of the contract, with delivery and payment at a specified future date

not standardized

46

## futures

###
forward-based standardized contracts to take delivery of a specified financial instrument, foreign currency, or commodity at a specified future date or during a specified period generally at the then market price

much more specific than forwards (were going to sell you 200 boxes of corn for $50,000 between september 1 and 15th)

standardized and can trade in the futures market

47

## currency swaps

### forward-based contracts in which two parties agree to exchange an obligation to pay cash flows in one currency for an obligation to pay in another currency

48

## interest rate swaps

###
forward-based contracts in which two parties agree to swap streams of payments over a specified period of time

example: one party agrees to make payments based ona fixed rate of interest and the other party agrees to make payments based on a variable rate of interest

49

## swaption

###
an option of a swap that provides the holder with the right to enter into a swap at a specified future date with specific terms, or to extend or terminate the life of an existing swap

these derivatives have characteristics of an option and interest rate swap

50

## forward contracts and swaps are often created and exchanged by financial intermediaries, such as

###
commercial banks

insurance companies

pension funds

savings and loan associations

mutual funds

finance companies

investment bankers

money market funds

credit unions

51

## counterparty

### the other party to the contract or agreement

52

## risks in using derivatives

###
1. credit risk

2. market risk

3. basis risk

4. legal risk

53

## credit risk (derivatives)

### the risk of loss as a result of the counterparty to a derivative agreement failing to meet its obligation

54

## market risk (derivatives)

###
the risk of loss from adverse changes in market factors that affect the fair value of a derivative

such as interest rates, foreign exchange rates, and market indexes for equity securities

55

## basis risk (derivatives)

###
the risk of loss from ineffective hedging activities

basis risk is the difference between the fair value (or cash flows) of the hedged item and the fair value (or cash flows) of the hedging derivative

the entity is subject to the risk that fair values will change so that the hedge will no longer be effective

56

## legal risk (derivatives)

### the risk of loss from a legal or regulatory action that invalidates or otherwise precludes performance by one or both parties to the derivative agreement

57

## use of derivatives

###
1. speculation: as an investment to speculate on price changes in various markets

2. hedging: to mitigate a business risk that is faced by the firm. hedging is an activity that protects the entity against the risk of adverse changes in the fair values or cash flows of assets, liabilities, or future transactions. a hedge is a defensive strategy.

58

## FASB ASC Topic 815 provides guidance on three types of hedging activities

###
1. fair value hedge

2. cash flow hedge

3. foreign currency hedge

59

##
fair value hedge

of a recognized asset or liability or of an unrecognized firm committment

###
a hedge of the changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk

executory contract or purchase order

60

##
cash flow hedge

of a recognized asset or liability or of a forecasted transaction

###
a hedge of the variability in the cash flows of a recognized asset or liability, or of a forecased transaction, that is attributable to a particular risk

you're thinking about it

61

## foreign currency hedges

###
1. a fair value hedge of an unrecognized firm commitment or a recognized asset or liability valued in a foreign currency (a foreign currency fair value hedge)

2. a cash flow hedge of a forecaseted transaction, an unrecognized firm commitment, the forecasted functional-currency-equivalent cash flows associated with a recognized asset or liability, or a forecasted intercompany transaction (a foreign currency cash flow hedge)

3. a hedge of a net investment in a foreign operation

*treated like a fair value hedge or a cash flow hedge

62

## 3 types of securities

###
1. treasury bills- 90 days

2. treasury notes- 1 year

3. treasury bonds- 15 years

63

## in general Topic 815 requires an entity to report all derivatives as assets and liabilities on the

###
balance sheet (statement of financial position) measured at fair value (written up or down)

unrealized gains and losses attributed to changes in a derivative's fair value are accounted for DIFFERENTLY, depending on whether the derivative is designated and qualifies as a hedge

64

## accounting for a fair value hedge

###
there is an effective portion and an ineffective portion --> both go to income from continuing operations

65

## accounting for any derivative held for speculative reasons

### the unrealized holding gains go to income from continuing operations-- show up in net income

66

## accounting for a cash flow hedge

###
there is an effective portion and an ineffective portion

the effective portion goes to other comprehensive income and is reported net of the tax effect

the ineffective portion goes to income from continuing operations

67

## accounting for foreign currency operations

### treated like fair value hedge or foreign currency hedge

68

## value derivatives at

###
fair value

thats why they have unrealized gains or losses

69

## two ways to value derivatives

###
1. Black-Sholes option-pricing model

2. Zero-coupon method

70

## Black-Sholes option-pricing model

###
a mathematical model for estimating the price of stock options using the following five variables:

1. time to expiration of the option

2. exercise or strike price

3. risk-free interest rate

4. price of the underlying stock

5. volatility of the price of the underlying stock

this is the option used to value a derivative when there is no quoted market price

other methods used to value options include monte-carlo simulation and binomial trees

71

## Zero-coupon method

###
used to determine the fair value of interest rate swaps

a present value model in which the net settlements from the swap are estimated and discounted back to their current value

key variables in the model include:

1. estimated net settlement cash flows

2. timing of the cash flows as specified by the contract

3. discount rate

72

## bonds

###
generally provide for periodic fixed interest payments at a coupon (contract) rate of interest

at issuance, or thereafter, the market rate of interest for the particular type of bond may be above, the same, or below the coupon rate

73

## discounted bond

### if the market rate exceeds the coupon rate, the book value will be less than the maturity value

74

## premium bond

### the coupon rate exceeds the market rate, the bond will sell for more than maturity value to bring the effective rate to the market rate

75

## par bond

### when the coupon rate and the market rate equal each other

76

##
coupon rate

contract rate

stated rate

nominal rate

bond rate

###
all the same thing

mean: rate of interest that is paid to bondholders

77