Study Unit 5

Question 1

ROI

Answer 1

Amnt rec’d-Amnt invested

Question 2

Rate of return

Answer 2

ROI/Amnt invested

Question 3

Systematic risk

Answer 3

mkt risk (undiversifiable risk)
risk faced by all firms
changes in economy as a whole (inflation, business cycle)
all investments affected

Question 4

Unsystematic risk

Answer 4

unique risk or company risk
determined by industry, products, customer loyalty, degree of leverage, mgt competence,

diversifiable risk

Question 5

Types of investment risk

Answer 5

credit default
liquidity
maturity (interest rate)
inflation
political
exchange 
business
country
principal

Question 6

Credit default

Answer 6

risk borrower will default and won’t pay principal or interest; gauge by using credit-rating agencies

Question 7

Liquidity

Answer 7

security can’t be sold on short notice for MV

Question 8

Maturity risk

Answer 8

interest rate risk
risk an investment security will fluctuate n value bet date of issue and date of maturity
longer the date of maturity, higher the risk

Question 9

Political risk

Answer 9

probability of loss from actions of govts (tax law changes, environmental regs)

Question 10

Exchange rate risk

Answer 10

risk of loss bc of fluctuation in relative value of foreign currency

Question 11

business risk

Answer 11

operation risk
risk of earning fluctuations before interest and taxes or in operating income when firm doesn’t use debt
-risk inherent in its ops that excludes financial risk (risk to shareholders from use of financial leverage)
-depends on demand variability, sales price variability, input price variability, amnt of op leverge

Question 12

Country risk

Answer 12

overall risk of investing in a foreign country

Question 13

principal risk

Answer 13

risk of losing the amnt invested

Question 14

risk averse

Answer 14

utility of gain doesn’t outweigh dis utility of potential loss of the same amnt

Question 15

risk neutral

Answer 15

investors adopts expected value approach bc they regard utility of gain as = to dis utility of a loss of same amnt

Question 16

risk seeking

Answer 16

optimistic attitude toward risk

utility of gain as exceeding dis utility of loss of same amnt

Question 17

risk premium

Answer 17

excess of investment’s expected RoR over risk free interest rate (interest rate on safest investment, rate on US T bill)

T bill holder only exposed to inflation risk; mkt rate of interest = risk free rate of interest + inflation premium

Question 18

required rate of return

Answer 18

return that takes into account all investment risks that relate to specific security

Real risk free rate + inflation premium=risk free rate
risk free rate+ liquidity risk premium + default risk premium+ maturity risk premium= required rate of return

Question 19

Debt securities

Answer 19

income bonds pay return only if issuer is profitable
debentures are unsecured
mtg bonds are secured by real property
T bonds backed by US govt

Question 20

Precious metal

Answer 20

risky b/c of volatility

when high inflation, currency loses purchasing power & may be safe investment

Question 21

Probability distribution

Answer 21

set of all possible outcomes for decision

discrete b/c outcomes are limited

Question 22

expected rate of return

Answer 22

investment determined using an expected value calculation
avg of possible outcomes weighted wrt probabilities
Ex RoR= sum (possible rate of return * probability)

Question 23

Risk

Answer 23

chance actual return differs from expected
risk=std dev (variance) of investment’s return
std dev= sq rt[sum(possible rate of return-expected rate of return)^2 * probability]= sq rt (variance)

Question 24

Coefficient of variation

Answer 24

measures risk per unit of return
CV=std dev/expected rate of return
lower the ratio better the risk return tradeoff

Question 25

Diversification expected portfolio return portfolio risk

Answer 25

weighted avg of returns on indiv securities less than a simple avg of the std deviations of component securities; benefit of diversification benefits decrease when more than 20-30 different securities are held

Question 26

coefficient of correlation

Answer 26

measures degree to which any 2 variables (prices) are related - range from 1.0 to -1.0 - perfect positive (1.0) means variables move together - perfect negative (-1.0) mans variables move opposite - normal range of 2 random stocks is .5 -.7

Question 27

CAPM

Answer 27

quantifies req ROE security by relating security's level of risk to avg return available in the mkt (portfolio) based on idea investor is compensated in 2 ways (time value of $ and risk) -time value is risk free rate -risk component consists of market risk premium (Rm-Rf) and beta

Question 28

market risk premium

Answer 28

return provided by mkt over and above risk free rate | varies in direct proportion to beta

Question 29

beta

Answer 29

measure of security's risk - effect of indiv security on volatility measured by sensitivity to movements of overall mkt - beta of mkt=1, beta of US treasury = 0

Question 30

security risk premium

Answer 30

beta(Rm-Rf)

Question 31

CAPM formula

Answer 31

required RoR Rf + beta(Rm-Rf) Rm-market return

Question 32

derivative instrument

Answer 32

investment trans in which the gain or loss derived from some other economic event (price of stock, foreign currency exchange rate, price of commodity) -one party enters into trans to speculate (incur risk) other enters into it to hedge (avoid risk)

Question 33

Hedging

Answer 33

offsetting instrument to minimize or avoid impact of adverse $ movement -takes position correlated with original asset but in opposite direction long position- entity owns asset, benefits when value increases short position- entity sells asset it doesn't own at time of sale; take position when believe value will decrease (borrow asset from entity that owns it before "short sale")

Question 34

Options

Answer 34

buyer holds all rights; seller has all of obligation buyer pays fee to dictate in future whether seller buys or sells underlying asset from or to the buyer holder- party buying option; exercise of option at holder's discretion writer- seller

Question 35

Exercise price

Answer 35

price holder can purchase (for call) or sell (put) the underlying asset -increase in exercise price decreases value of call option and increase in value of put option

Question 36

Price of underlying

Answer 36

price increases, value or call increases; exercise price is greater bargain with each adtl dollar in price of underlying value of put decrease as price of underlying increases, no advantage in selling at a lower than mkt price

Question 37

interest rate

Answer 37

rise in rate makes calls more attractive and increases value | rise in rate makes put option less attractive and decreases value

Question 38

Volatility of price of underlying

Answer 38

holder prefers greater volatility b/c more chance underlying price will change and option will be in-the-money more volatile, increase value of option

Question 39

intrinsic value of a call option

Answer 39

amnt by which exercise price is less than current price of the underlying positive i.v is in-the-money 0 i.v. out of the money