Module 43a: Financial Risk Management Flashcards Preview

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

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

to achieve higher returns an investor must assume greater risk


variance is the term used for

higher risk


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


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


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


risk neutral investors

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

these investors disregard risk


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


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)


ex post basis

"after the fact" investment return formula

therefore it does not consider risk


ex ante basis

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


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


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)


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)


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


coefficient of variation

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

=standard deviation/expected return


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


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



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


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


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.



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


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


interest rates

represent the cost of borrowing funds


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)


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


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


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


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


stated interest rate

the contractual rate charged by the lender


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


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


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


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


flat yield curve

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

ST = IR = LT


humped yield curve

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

IR > ST & LT


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)


theories that attempt to explain the yield curve

1. liquidity preference (premium) theory
2. market segmentation theory
3 expectations theory


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


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


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


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


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



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



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)



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



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


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


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



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


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



the other party to the contract or agreement


risks in using derivatives

1. credit risk
2. market risk
3. basis risk
4. legal risk


credit risk (derivatives)

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


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


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


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


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.


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

1. fair value hedge
2. cash flow hedge
3. foreign currency hedge


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


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


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


3 types of securities

1. treasury bills- 90 days
2. treasury notes- 1 year
3. treasury bonds- 15 years


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


accounting for a fair value hedge

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


accounting for any derivative held for speculative reasons

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


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


accounting for foreign currency operations

treated like fair value hedge or foreign currency hedge


value derivatives at

fair value

thats why they have unrealized gains or losses


two ways to value derivatives

1. Black-Sholes option-pricing model
2. Zero-coupon method


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


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



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


discounted bond

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


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


par bond

when the coupon rate and the market rate equal each other


coupon rate
contract rate
stated rate
nominal rate
bond rate

all the same thing

mean: rate of interest that is paid to bondholders


market rate
effective rate
yield to maturity
real rate

the market rate of interest for your bonds that are similar to yours

aka if someone is offering you a bond paying 6% and the market rate is 8% that bond is at a discount and you dont want it because you can go elsewhere and get the 8% bond