Financial Risk Management Exam 1

Expected return - answer-a weighted average of the possible returns, where the weight applied to a particular return equals the probability of that return occurring A: the cv reflects the effects of both risk & return - answer-q: why's the coefficient of variation (cv) a better measure of stand-alone risk that the standard deviation of an asset? A: one that minimizes risk & maximizes expected returns - answer-q: what's an "optimal" portfolio? A: add additional securities to our portfolio that will move us further in a northwest direction - answer-q: how can we form an optimal portfolio? Efficient frontier - answer---the limit of how far we can move in a northwest direction --represents all risk-return combo's that can be created by combining risky assets Southeast - answer-where are individual stocks plotted with respect to the efficient frontier? Diversification - answer-__________ allows us to create risk-return combo's that are superior to a single stock Return for a given level of risk (risk for a given level of return) - answer-the efficient frontier is superior because it represents portfolios that provide the greatest ___________ for a given level of __________ (or the least amount of __________ for a given level of _________). Efficient - answer-portfolios that provide the greatest return for a given level of risk are said to be ___________ New efficient frontier - answer-the capital market line (cml) is also known as _______ Market portfolio (m) - answer-the tangency point on the cml that indicates the portfolio of risky assets that's best to combine with the risk-free asset is known as ____ Market portfolio (m) - answer-on the cml, the ___________ is the optimal portfolio of risky assets for all investors Risk-free (f) & risky (m) - answer-on the cml: since all investors differ in their tolerance to risk, they will allocate different amounts to the _______ & ________ assets More Less - answer-as an investor's risk aversion increases, he will allocate _______ to f and _________ to m Borrowing @ the risk-free rate and investing his original funds and the borrowed funds exclusively in m - answer-on the cml: an investor can achieve points above m on the cml by doing what? Same portfolio Apetite for risk - answer-cml: all investors should choose the ________ __________ of risky assets (m) and reflect their _______ _____ _______ by combining this risk investment with borrowing or lending the risk-free asset Nonsystematic risk - answer---the portion of a stock's risk that is attributable to factors specific to that one stock --thus, this risk can be offset by investing in stocks that don't share that factor --aka company-unique risk, diversifiable risk --ex) lawsuit outcomes, regulatory rulings, issues with management team, new product launches Systematic risk - answer---refers to the portion of a stock's risk that's attributable to factors that affect all stocks to some degree --this risk is inherent to the entire economic system, and thus cannot be reduced by diversification --ex) economic news, catastrophes, oil prices or interest rates changing unexpectedly, warren buffet saying "sell everything!" --aka market risk, nondiversifiable risk Capital asset pricing model (capm) - answer-equation that equates the expected return on a stock to the risk-free rate plus a risk premium due to the stock's systematic risk Beta of security i - answer-______ tells us how many times the market risk premium is deserved as a risk premium for security i. Equal to the risk-free rate - answer-what's the expected return of a stock with a beta of 0? Equal to the market portfolio - answer-what's the e(r) for a security with a beta of 1? Security market line (sml) - answer-the _________ is a graphical representation of the capm equation that represents the e(r) for a level of beta. Underpriced Buy it! - answer-if an asset's actual return is above its e(r) (above the sml), it's ____________. What should you do with it? Overpriced Sell it! - answer-if an asset's actual return is below it's e(r) (below the sml), it's ________. What should you do with it? Alpha - answer-when a portfolio manager produces a higher return than what is expected given the amount of systematic risk, the extra return is referred to as _________. Return on the market portfolio - answer-what single factor does an asset's return depend on in capm? Arbitrage pricing theory (apt) - answer-in _______ ________ _________ an asset's return depends on several factors, such as the gross national product, domestic interest rates, and the inflation rate. Each factor is a source of systematic risk. Commercial banking - answer-what form of banking takes in deposits and makes loans? Investment banking - answer-______ _________ assists companies in raising debt & equity, provides advice on m&a's, major corporate restructuring, and other corporate finance decisions Net interest income Loan losses Non-interest income Non-interest expense - answer-how do you get pre-tax operating income on a commercial bank's income statement? Interest rev - interest exp - answer-formula for net interest income Borrowers default - answer-loan losses are an inevitable aspect of banking and occur when _______ __________. Non-interest income - answer-what represents all income received from activities other than lending? (ex. Service fees) Non-interest expense - answer-what represents all expenses paid other than interest? (ex. Salaries) A bank run - answer-what's it called when all depositors decide to withdraw at the same time? Poor credit quality - answer-a provision for loan losses is used to account for loans that are of ______ ________ ______ and expected to decline in the future. Asset - answer-what kind of account are loans? Expense - answer-what kind of account is provision for loan losses? Contra-asset - answer-what kind of account is the allowance for loan losses? Debit: provision for loan losses Credit: allowance for loan losses - answer-journal entry for: estimates of future loan losses Debit: allowance for loan loss Credit: loans - answer-journal entry: when actual loan loss occurs Estimate of future loan loss (provision for loan losses is an exp) - answer-which journal entry impacts net income? Overestimating Underestimating - answer-a bank can smooth out its income from one year to the next by ________ reserves in good years and _________ them in bad years. Private placement - answer-when securities are sold to a small number of large institutional investors Public offering - answer-where securities are offered to the general public Prospectus Road show - answer-key phases of the ipo process include filing a _________, which includes the details of the offering (such as its price and size), and to go on a _______ _______, which is the company's chance to interact with prospective investors and gauge demand for their upcoming ipo. Dutch auction approach **could be short answer - answer-**maybe short answer In this ipo approach, individuals & companies bid on the ipo by indicating the number of shares they want and the price they are prepared to pay. Shares are first issued to the highest bidder, then to the next highest bidder, and so on, until all shares have been sold. The price paid by all successful bidders is the lowest bid that leads to a complete share allocation. 1) to satisfy the needs of their clients 2) to manage the firm's risk 3) to exploit pricing inefficiencies 4) to bet on the direction in which market prices will move - answer-financial institutions trade in a variety of financial instruments for one or more of several reasons: (what are the reasons?) Open outcry - answer-exchange-traded markets were originally established as an _______ _____