Topic 14: Risk

Question 1

Define risk adverse, risk neutral and risk loving.

Answer 1

• Risk adverse: An agent is risk adverse when they prefer the mean of a prospect with certainty, then the outcome to that uncertain prospect.
• Risk neutral: Indifferent between …
• Risk loving: Prefers …

Question 2

What is the definition of risk?

Answer 2

The probability of an outcome differing from the expected outcome, implying both favourable and unfavorable outcomes with a notion of their probability spread

Question 3

What is exposure?

Answer 3

A measure of sensitivity of what is at risk to sources of risk.

Question 4

What kinds of exposure are there?

Answer 4

• Transactions
• Translation
• Economic

AND

• Long
• Short

Question 5

Define long exposure. Illistrate with a graph.

Answer 5

Exposure to foreign assets, due to the change in d.c. value that will occur with changes to the exchange rate.

As V^o = βS^o

where β = a measure of exposure ( > 0), we can illustrate this as an exposure line:

Question 6

What is short exposure?

Answer 6

The exposure to a foreign liability. If in the forex is:

V^o = β S^o

Where o indicates proportional change.

Question 7

What is combined exposure? How can we illustrate it?

Answer 7

• The sum of short and long exposure.
• We graph them both together
• Note that net gain / loss is not clear, as nominal amounts of assets / liabilities is not given.

Question 8

What is transactions exposure?

Answer 8

Foreign exchange risk exposure when you have a payable/receivable in a foreign currency, whose f.c. value is known but d.c. value not so due to exchange rate uncertainty.

Question 9

What is economic exposure?

Answer 9

Exposure of the value of the asset to any risk at all. (Inclusive of transactions exposure.)

Question 10

What is translation exposure?

Answer 10

Accounting exposure, where the book value of a corporation varies with some unknown variables.

Question 11

Outline the argument that states firms should not care about risk. What problems are there with this arguement?

Answer 11

Argument:

• Firms exist to give shareholders a profit.
• Because shareholders can eliminate risk through diversification, firms should aim to maximise profit, and let shareholders manage risk through their porfolios.

Problems:

• Taxation favours low risk firms.
• If the firm collapses all future earnings are gone.