Risk Management

Question 2

Define Market Risk

Answer 2

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

Question 3

Define Sector Risk

Answer 3

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

Question 4

Define Interest Rate Risk

Answer 4

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.

Question 5

Define Credit/Default Risk

Answer 5

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

Question 6

What does Standard Deviation measure?

Answer 6

It measures the volatility of an investment.

Question 7

What is Systematic Risk?

Answer 7

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

Example: Wars

Question 8

What is Unsystematic Risk?

Answer 8

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

Question 9

What does Beta measure?

Answer 9

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?

Question 10

What is Variance?

Answer 10

It compares volatility of an investment to the market average.

Factors include both Systematic and Unsystematic Risk.

Question 11

What is a Derivative?

Answer 11

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

Derivatives are measured at Fair Value.

Question 12

How is an Option used?

Answer 12

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

Question 13

What is a Future?

Answer 13

A Forward Contract with a future value.

They are sold and traded on the futures market.

Question 14

What is an Interest Rate Swap?

Answer 14

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

Question 15

What is Legal Risk?

Answer 15

Risk that a law or regulation will void the derivative

Question 16

What is a Fair Value Hedge?

Answer 16

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

Changes in value are reported in earnings.

Question 17

What is a Foreign Currency Hedge?

Answer 17

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.

So you will sell the currency today, so you can receive an amount equivalent today’s rate, this will offset the lower amount received in the future.

If it was a payables - you would buy the currency today to offset the amount you would have to pay in the future.

Question 18

What is a Cash Flow Hedge?

Answer 18

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

Changes in value are reported in OCI.

Question 19

What are the two types of options?

Answer 19

Call Option allows a holder to buy a specific commodity or financial instrument for a specified period of time.

Put Option allows a holder to sell a specific commodity or financial instrument for a specified period of time

Question 20

What is the measure at which different investments move together?

Answer 20

Covariance or Correlation also called Coefficient of Variation - calculation is SD/ER

A low covariance eliminates unsystematic risk (unique/avoidable)

A negatively correlated (negative covariance) - creates a balance portfolio - investor is offsetting risks - because as one investment goes down the others will go upp

Question 21

What is the mean variance optimization?

Answer 21

A technique used when the expected returns and covariance are known and can be used to identify the specific portfolio that will for for a particular level of volatility have the highest expected return

Question 22

What is the term used for a portfolio that has the highest mean return for a particular variance (volatility)

Answer 22

It is an efficient portfolio - and a chart that plots the efficient portfolios is the efficient frontier

Question 23

Describe the types of Yield Curves (term structure of interest rates)?

Answer 23

Interest rates charged on loans (and paid on bonds) varies based on the term of the loan.

Normal Yield Curve - upward slopping - ST rates are less than long term

Inverted Yield Curve - downward slopping - ST rates are greater than intermediate which are greater than long-term

Flat - all rates are the same - ST, LT, and intermediate

Humped Curve - intermediate rates are greater than both short term and long term

Question 24

What are the theories associated with the differences in yields?

Answer 24

Liquidation Preference - Since long term loans are less liquid and have more interest rate risk - they offer higher rates than short term

Market Segmentation - Different lenders will dominate in different loan lengths - banks favor short term, savings and loan favor intermediate, and life insurance favor long term

Expectations - long term rates reflect expected changes in future short term rates with inflation expectations playing a major part in determining such rates.