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Flashcards in Risk Management Deck (37):

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 volatility of an 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.

In other words- how quickly (and in what amount) does the value of the stock change when the market sways?


What is Variance?

It compares volatility of an investment to the market average.

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.



Required rate of return (RRR)
Rf-Rm market risk premium
£(Rm-Rf) security risk premium


£ security risk

£=1 expected return = market return
£=0 US Treasury security
£=1.4 systematic risk is higher than that of the market


€ sigma standard deviation

Measure riskiness of the investment, the smaller the lower risk


r coefficient of correlation

1.0 -1.0
r=1 two variances move together
r=-1 unsystematic risk can be eliminated


Sensitivity analysis

Examined how the model's outcomes change as the parameters change


Expected value analysis

Is used to determine an anticipated return or cost based upon probabilities of events and their related outcomes. It is arithmetic mean using probabilities as weights


r coefficient if correlation

Us the strength of the linear relationship b/w 2 variables from 1 to -1. r=1 very strong relationship


r^2 coefficient of determination

Measure of how good the fit b/w the independent and dependent variables is. The closer the value to 1 the more useful the independent variable



One of the company's objective is to minimize the wacc


Trade related factors

Relative income
Trade barriers
Relative inflation rate


Decision tree analysis

Diagram that analyze sequences of probabilistic decisions, the events that may follow each decision and their outcomes


Linear programming

Used to minimize a cost function or maximize a profit function given constraints


Queuing theory

Used to minimize the cost of waiting lines


Monte Carlo simulation

Mathematical model, is a technique to generate the individual values for a random variable.
Adv: time can be compressed, alternative policies can be considered, complex system can be analyzed



Forecasting method relies mostly on judgment


Econometric models

Apply statistical methods to the study of economic problem and data


Sensitivity analysis

Examine how the models outcomes change as the parameters change


Beta is equal 1.4

Systematic risk is higher than that if the market portfolio


Ordinary annuity

Payment received at the end of period


Annuity due

Payment is made in the beginning of the period