Financial Risk Management

The risk that purchasing power will be lost while the loan is at the borrower's disposal - answer-Inflation risk The probability of loss from actions of governments, such as changes in tax laws or environmental regulations or expropriation of assets - answer-Political risk The risk of loss because of fluctuation in the relative value of foreign currency - answer-Exchange rate risk The risk of fluctuations in earnings before interest and taxes or in operating income when the firm uses no debt - answer-Business risk What is another name for business risk? - answer-Operations risk What does business risk exclude? - answer-Financial risk What is financial risk? - answer-The risk to the shareholders of financial leverage What factors does business risk depend on? - answer-1) Demand variability 2) Sales price variability 3) Input price variability 4) The amount of operating leverage The overall risk of investing in a foreign country - answer-Country risk The risk of losing the principal invested - answer-Principal risk What determines whether the expected return on an investment suffices to attract an investor? - answer-1) Its risk 2) The risks and returns of alternative investments 3) The investor's attitude toward risk What are most investors in regards to risk? - answer-Risk averse Because of risk aversion, risky securities must have...... - answer-Higher expected returns Regards the utility of a gain as equal to the disutility of a loss of the same amount - answer-Risk neutral Regards the utility of a gain as exceeding the disutility of a loss of the same amount - answer-Risk seeking The excess of an investment's expected rate of return over the risk free interest rate - answer-Risk premium The interest rate on the safest investment - answer-Risk free rate Considers all investment risks that relate to a specific security - answer-Required rate of return The safety of an investment and its potential return have ___________________________ relationship - answer-An inverse Pay a return only if the issuer is profitable - answer-Income bonds What type of debt is unsecured? - answer-Debenture What is the best to invest in when inflation is coming? - answer-Precious metals The set of all possible outcomes of a decision, with probability assigned to each outcome - answer-Probability distribution The risk of a single stock - answer-Unsystematic risk What is it called because returns are limited? - answer-Discrete An average of the possible outcomes weighted according to their probabilities - answer-Expected rate of return What is the formula for Expected rate of return? - answer-=Sum ( Possible rate of return x Probability) The probability that the actual return on an investment will differ from the expected return - answer-Risk What is the formula for standard deviation? - answer-SQRT(sum ( (Ri - R)^2 x Probability ) ) Ri=Possible rate of return R=Expected rate of return Measures the tightness of the distribution and the riskiness of the investment - answer-Standard deviation The greater the standard deviation.... - answer-The riskier the investment Useful when the rates of return and standard deviations of two investments differ - answer-The coefficient of variation What does the coefficient of variation measure? - answer-The Risk per unit of return What is the formula for the Coefficient of Variation? - answer-Standard deviation ---------------------------- Expected rate of return The lower the ratio..... - answer-The better the risk return trade off The weighted average of the returns on the individual securities - answer-Expected portfolio return Usually less than a simple average of the standard deviations of the component securities - answer-Portfolio risk What is associated with one investment security? - answer-Specific risk What are other names for specific risk? - answer-Diversifiable risk Unsystematic risk Residual risk Unique risk In theory, diversifiable risk should continue to decrease as the number of different held securities...... - answer-Increases The benefits of diversification become extremely small when more than about __________ to _______ different securities are held - answer-20 30 The risk of the stock market as a whole - answer-Market risk Measures the degree to which any two variables are related - answer-Coefficient of correlation What is the range of coefficient of correlation? - answer--1.0 to 1.0 What does 1.0 mean? - answer-The two variables always move together What does -1.0 mean? - answer-The two variables always move in opposite direction The normal range for the correlation of two randomly selected stocks is _________ to __________ - answer-.50 .70 Quantitfies the required return on an equity security by relating the security's level of risk to the average return available in the market - answer-Capital Asset Pricing Model (CAPM) What is the CAPM formula based on? - answer-1) Time value of Money 2) Risk What is the time value component? - answer-Risk free rate What is the risk free rate? - answer-The return provided by the safest investments What does the risk component consist of? - answer-1) Market risk premium 2) Beta 3) Security risk premium The return provided by the market over the risk free rate - answer-Market risk premium A measure of the security's risk - answer-Beta What is the formula for the market risk premium? - answer-Rm - Rf What is the security risk premium formula? - answer-B x (Rm - Rf) What is the CAPM/Required rate of return formula? - answer-Rf + B x (Rm - Rf) All investments must lie on the ____________________________________ - answer-Security market line An investment transaction in which the parties' gain or loss is derived from some other event - answer-Derivative instrument What are examples of derivative instruments? - answer-1) The price of a given stock 2) A foreign currency exchange rate 3) The price of a certain commodity Derivative is a type of ______________________________________ - answer-Financial instrument Uses offsetting commitments to minimize or avoid the effect of adverse price movements - answer-Hedging An entity has a ____________________________ in an asset whenever the entity owns the asset - answer-Long position An entity with a long position _____________ from a rise in the asset's value - answer-Benefits An entity has a _________________________________ in an asset when the entity sells an asset that it does not own at the time of the sale - answer-Short position Entities take short positions when they believe ______________________________________________________ - answer-The value of the asset will decrease Who holds all the rights in the options? - answer-The buyer Gives the buyer the right to purchase the underlying asset at a fixed price - answer-Call option Gives the buyer the right to sell the underlying asset at a fixed price - answer-Put option The asset that is subject to being bought or sold under the terms of the option - answer-Underlying The party buying an option - answer-Holder The party selling an option - answer-Writer Options have a ___________________________ - answer-Expiration date What are the two best known models for valuing options? - answer-Black Scholes formula Binomial method The price at which the holder can purchase or sell the underlying asset in the option contract - answer-Exercise price