Module 43a: Financial Risk Management

Question 1

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

Answer 1

to achieve higher returns an investor must assume greater risk

Question 2

variance is the term used for

Answer 2

higher risk

Question 3

equity risk premium

Answer 3

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

chart on page 192

Question 4

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

Answer 4

is mean return on stocks minus mean return on bonds

Question 5

risk averse

Answer 5

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

Question 6

risk neutral investors

Answer 6

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

these investors disregard risk

Question 7

risk seeking investors

Answer 7

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

Question 8

investment return

Answer 8

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)

Question 9

ex post basis

Answer 9

“after the fact” investment return formula

therefore it does not consider risk

Question 10

ex ante basis

Answer 10

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

Question 11

estimating expected returns

Answer 11

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

Question 12

arithmetic average return

Answer 12

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)

Question 13

geometric average return

Answer 13

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)

Question 14

estimating risk

Answer 14

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

Question 15

coefficient of variation

Answer 15

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

=standard deviation/expected return

Question 16

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

Answer 16

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

Question 17

the variance of portfolio returns

Answer 17

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

Question 18

Covariance

Answer 18

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

Question 19

portfolios allow investors to diversify away unsystematic risk

Answer 19

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

Question 20

systematic risk

Answer 20

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.

Question 21

beta

Answer 21

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

Question 22

risk preference function

Answer 22

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

Question 23

interest rates

Answer 23

represent the cost of borrowing funds

Question 24

credit or default risk

Answer 24

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)

Question 25

interest rate risk

Answer 25

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

Question 26

market risk

Answer 26

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

Question 27

business risk

Answer 27

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

Question 28

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

Answer 28

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

Question 29

stated interest rate

Answer 29

the contractual rate charged by the lender

Question 30

effective annual interest rate

Answer 30

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

Question 31

the term structure of interest rates

Answer 31

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

Question 32

normal yield curve

Answer 32

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

Question 33

inverted (abnormal)yield curve

Answer 33

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

Question 34

flat yield curve

Answer 34

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

Question 35

humped yield curve

Answer 35

a curve in which intermediate term rates are higher than both short term and long term rates IR > ST & LT

Question 36

maturity risk premiums

Answer 36

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

Question 37

theories that attempt to explain the yield curve

Answer 37

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

Question 38

liquidity preference (premium) theory

Answer 38

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

Question 39

market segmentation theory

Answer 39

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

Question 40

expectations theory

Answer 40

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

Question 41

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

Answer 41

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

Question 42

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

Answer 42

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

Question 43

derivative

Answer 43

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

Question 44

options

Answer 44

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)

Question 45

forwards

Answer 45

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

Question 46

futures

Answer 46

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

Question 47

currency swaps

Answer 47

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

Question 48

interest rate swaps

Answer 48

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

Question 49

swaption

Answer 49

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

Question 50

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

Answer 50

``` commercial banks insurance companies pension funds savings and loan associations mutual funds finance companies investment bankers money market funds credit unions ```

Question 51

counterparty

Answer 51

the other party to the contract or agreement

Question 52

risks in using derivatives

Answer 52

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

Question 53

credit risk (derivatives)

Answer 53

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

Question 54

market risk (derivatives)

Answer 54

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

Question 55

basis risk (derivatives)

Answer 55

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

Question 56

legal risk (derivatives)

Answer 56

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

Question 57

use of derivatives

Answer 57

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.

Question 58

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

Answer 58

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

Question 59

fair value hedge of a recognized asset or liability or of an unrecognized firm committment

Answer 59

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

Question 60

cash flow hedge of a recognized asset or liability or of a forecasted transaction

Answer 60

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

Question 61

foreign currency hedges

Answer 61

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

Question 62

3 types of securities

Answer 62

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

Question 63

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

Answer 63

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

Question 64

accounting for a fair value hedge

Answer 64

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

Question 65

accounting for any derivative held for speculative reasons

Answer 65

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

Question 66

accounting for a cash flow hedge

Answer 66

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

Question 67

accounting for foreign currency operations

Answer 67

treated like fair value hedge or foreign currency hedge

Question 68

value derivatives at

Answer 68

fair value thats why they have unrealized gains or losses

Question 69

two ways to value derivatives

Answer 69

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

Question 70

Black-Sholes option-pricing model

Answer 70

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

Question 71

Zero-coupon method

Answer 71

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

Question 72

bonds

Answer 72

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

Question 73

discounted bond

Answer 73

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

Question 74

premium bond

Answer 74

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

Question 75

par bond

Answer 75

when the coupon rate and the market rate equal each other

Question 76

``` coupon rate contract rate stated rate nominal rate bond rate ```

Answer 76

all the same thing mean: rate of interest that is paid to bondholders

Question 77

``` market rate effective rate yield yield to maturity real rate ```

Answer 77

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