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Flashcards in Risk Management Deck (17):
1

Define Market Risk

The risk that a sluggish economy

will affect the value of a debt instrument

2

Define Sector Risk

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

Ex: the banking sector is sluggish- so even stocks of healthy banks suffer

3

Define Credit/Default Risk

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

4

Define Interest Rate Risk

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

Ex: 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.

5

What does Standard Deviation measure?

It measures the volatility of an investment.

6

What is Systematic Risk?

  • Risk that impacts the entire market
  • can't be avoided/reduced through diversification

Ex: Wars

7

What is Unsystematic Risk?

Relates to a particular industry or company

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

8

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?

9

What is Variance?

It compares volatility of an investment to the market average.

Factors include both Systematic and Unsystematic Risk.

10

What is a Derivative?

  • An asset whose value is DERIVED from the value of another asset.
  • Derivatives are measured at Fair Value.

11

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

12

What is a Future?

A Forward Contract with a future value.

They are sold and traded on the futures market.

13

What is an Interest Rate Swap?

  • Forward Contract to swap payment agreements
  • They are highly liquid
  • often valued using the Zero-Coupon method.

Ex: Steve pays Sally a fixed payment with a fixed interest rate. Sally pays Steve a variable paymt tied to a benchmark i.e. LIBOR

14

What is Legal Risk?

Risk that a law or regulation will void the derivative

15

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.

16

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.

17

What is a Foreign Currency Hedge?

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

Ex: 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.