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Flashcards in Risk Management Deck (22):

Define Market Risk

The risk that a sluggish economy will affect the value of a debt instrument


Define Sector Risk

The risk that an event in the investment’s business sector will harm the investment

For example- the banking sector is sluggish- so even stocks of healthy banks suffer


Define Credit/Default Risk

The risk that a debtor will be unable to make loan payments or pay back the principal


Define Interest Rate Risk

The risk that a change in interest rates will adversely affect the value of the note

Example: Bond is for 10% but prevailing market rate is now 12%. If bondholder wants to sell it- they will have to sell it at a discount.


What does Standard Deviation measure?

It measures the dispersion of individual's stock returns.

Volatility of investment


What is Systematic Risk?

Risk that impacts the entire market and can’t be avoided or reduced through diversification

Example: Wars


What is Unsystematic Risk?

Relates to a particular industry or company

Example: You own stocks in ethanol plants and an untimely freeze kills all of the corn in the Midwest


What does Beta measure?

Beta measures how volatile the investment is relative to the rest of the market.

Measure of systematic risk of investment

Positive = moves with portfolio
Negative = moves against portfolio (want this)


What is Variance?

It compares volatility of an investment to the market average.

Depends on
- Portfolio weighting
- Variance of individual asset returns
- Covariance among returns of assets

Factors include both Systematic and Unsystematic Risk.


What is a Derivative?

An asset whose value is DERIVED from the value of another asset.

Derivatives are measured at Fair Value.


How is an Option used?

Gives the buyer the option to buy or sell a financial derivative at a certain price

Traders use them to speculate where they think the price will be at a certain point and make a profit

Hedgers use them to offset risk


What is a Future?

A Forward Contract with a future value.

They are sold and traded on the futures market.


What is an Interest Rate Swap?

Forward Contract to swap payment agreements

They are highly liquid and often valued using the Zero-Coupon method.

Example: Steve pays Sally a fixed payment with a fixed interest rate. Sally pays Steve a variable payment tied to a benchmark such as LIBOR


What is Legal Risk?

Risk that a law or regulation will void the derivative


What is a Fair Value Hedge?

Hedge that protects against the value of an asset or liability changing.

Changes in value are reported in earnings.


What is a Cash Flow Hedge?

A hedge that protects against a set of future cash flows changing.

Changes in value are reported in OCI.


What is a Foreign Currency Hedge?

A hedge that protects against the value of a foreign currency changing.

For example- a foreign currency hedge might be used to protect against the following: If you have receivables denominated in a foreign currency and that currency dips in value – your receivables are worth less than before.


What are the components of risk management?

Internal Environment
Objective Setting
Event Identification
Risk Assessment
Risk Response
Control Activities
Information and Communication


What is the difference between risk appetite and risk tolerance?

Risk appetite is the amount of risk a firm is willing to accept to achieve its goals

Risk tolerance is the acceptable variation with respect to a particular objective


How do you calculate the coefficient of variation and what does it measure?

= Standard Deviation / Expected Return

Compares risk of stock to expected return


How do you calculate the effective annual interest rate?

1 + (Stated Annual Rate / Compounding Frequency)

To the power of the Compounding Frequency

Then subtract 1


What is basis risk?

The risk that a derivative might be ineffective at hedging particular asset