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SU 5
Financial Risk Management
60
Accounting
Undergraduate 4
05/16/2015

Additional Accounting Flashcards

 


 

Cards

Term
rate of return
Definition
amount received by an investor as compensation for taking on the risk of the investment
Term
return on investment (ROI)
Definition
ROI = income / average invested capital
ROI = net income / total assets
DuPont ROI = profit margin * asset turnover
Term
compounding
Definition
interest generated by an investment either disbursed periodically in the form of cash or rolled into the investment principal
Term
systematic/market risk
Definition
risk faced by all firms; caused by changes in the economy as a whole. Only risk associated with a well-diversified portfolio (in which 20-30 securities are held).
Term
unsystematic/unique/diversifiable risk
Definition
risk inherent in a particular investment
Term
credit default risk
Definition
borrower will default on loan; credit-rating agencies
Term
liquidity risk
Definition
security cannot be sold or short notice for its market value
Term
maturity/interest rate risk
Definition
security will fluctuate in value between time issue and maturity date
Term
inflation risk
Definition
purchasing power will be lost during term of loan
Term
political risk
Definition
probability of loss from government action
Term
exchange rate risk
Definition
fluctuation in relative value of foreign currency
Term
business/operations risk
Definition
fluctuations in EBIT or in operating income when the firm uses no debt
Depends on demand, sales price, input price variability and operating leverage.
Excludes financial risk- risk to shareholders from the use of financial leverage.
Term
(non-investment risk) financial risk
Definition
risk to shareholders from the use of financial leverage.
Term
risk-averse
Definition
utility of gain does not outweigh the disutility of a potential loss of the same amount.
Term
risk-neutral
Definition
utility of gain equals the disutility of a potential loss of the same amount; expected value approach
Term
risk-seeking
Definition
utility of gain exceeds the disutility of a potential loss of the same amount
Term
market risk premium
Definition
excess of investment's expected rate of return over the risk-free rate (rM - rRF)
Term
rate of return formula
Definition
rate of return = (amount received – amount invested) / amount invested
Term
risk-free rate
Definition
safest investment; backed by T-bills
rRF = rRF + IP (only inflation risk occurs with T-bills)
Term
required rate of return
Definition
return that takes into account all the investment risks that relate to a specific security
Term
common shareholders
Definition
last in priority in company liquidation, but can receive excess profits
Term
convertible preferred stock
Definition
convertible into common shares
Term
preferred stock
Definition
above common shareholders in terms of liquidation, but returns capped by the BOD
Term
income bonds
Definition
pay a return only if the issuer is profitable
Term
subordinated debentures
Definition
unsecured
Term
first and second mortgage bonds
Definition
backed by real property
Term
U.S. T-bonds
Definition
backed by full faith and credit of U.S. government
Term
probability distribution
Definition
set of all possible outcomes of a decision, with a probability assigned to each outcome
Term
discrete
Definition
probability distribution in which outcomes are limited
Term
expected rate of return (R-bar)
Definition
average of the possible outcomes weighted according to their probabilities
R-bar = possible rate of return (Ri) * probability
Term
risk
Definition
chance that the actual ROI will differ from the expected return. Measure risk with SD of distribution of return.
Term
standard deviation (SD) formula
Definition
square root of (Ri - R)2 * probability)
Ri = possible rate of return
R = expected rate of return
square root of variance
Term
standard deviation
Definition
measures tightness of distribution and riskiness of the investment; the smaller the SD, the tighter the probability distribution and the lower the risk
Term
coefficient of variation (CV)
Definition
used to determine the best investment in terms of the risk-return tradeoff; useful when rates of return and SDs differ. Measures risk per unit of return.
Term
CV formula
Definition
CV = st. dev. / expected rate of return. Lower CV = better risk-return tradeoff.
Term
goal of portfolio management
Definition
Construct a basket of securities to generate a reasonable return without the risks of holding a single security (diversification). Diversification also reduces aggregate volatility.
Term
coefficient of correlation (r)
Definition
measures the degree to which any two variables (two stocks) are related.

Normal r value for two randomly selected stocks is .5 - .7.
Term
perfect positive correlation
Definition
1.0; the two stocks always move together. No specific/diversifiable risk is eliminated.
Term
perfect negative correlation
Definition
-1.0; the two stocks always move away from each other. All specific/diversifiable risk is eliminated.
Term
capital asset pricing model (CAPM)
Definition
CAPM quantifies the required return on an equity security by relating the security's level of risk to the average return available in the market.
Investor must be compensated for time value of money and risk.
Term
CAPM formula
Definition
Required rate of return = rRF + (rM – rRF)b
risk-free rate = rRF
market return = rM
market risk premium (rM – rRF)
beta (b)
Term
beta
Definition
measure of the systematic/market risk or volatility of the individual security in comparison to the market (diversified portfolio) (b)
beta of market = 1.
beta of T-securities = 0.
beta > 1 = systematically riskier than the market.
Term
security market line
Definition
The market risk premium varies in direct proportion to beta. Therefore, all investments (securities) must lie on the security market line.
Term
derivative investment
Definition
investment transaction in which the parties' gain or loss is derived from some other economic event (some underlying asset price)
Term
hedging
Definition
process of using offsetting commitments to minimize or avoid the impact of adverse price movements. Entity takes a position in the financial instrument that is almost perfectly correlated with the original asset but in the opposite direction.
Term
long position
Definition
entity owns the asset, so benefits when asset rises in value
Term
short position
Definition
entity sells asset it does not own, anticipating a decline in value (asset is borrowed)
Term
option
Definition
holder buys the right to demand that the seller (writer) buy or sell an underlying asset on or before a specified future date. Buyer holds rights and seller holds obligations. Buyer pays fee for these rights.
Term
call option
Definition
gives buyer right to purchase underlying at a fixed price
Term
put option
Definition
gives buyer right to sell the underlying at a fixed price
Term
underlying
Definition
asset subject to being bought or sold under option terms
Term
When can an option be exercised?
Definition
On or before the expiration date.
Term
option premium
Definition
intrinsic value + time premium
Term
exercise price
Definition
price at which the holder can purchase (call option) or sell (put option) the asset underlying the option contract
Term
intrinsic value of a call option
Definition
amount by which exercise price is less than the current price of the underlying
positive intrinsic value = in-the-money
intrinsic value of $0= out-of-the-money
Term
intrinsic value of a put option
Definition
amount by which exercise price is greater than the current price of the underlying
positive intrinsic value = in-the-money
intrinsic value of $0= out-of-the-money
Term
time premium
Definition
the more time that exists between the writing of an option and its expiration, the riskier any investment is. Buyer can only lose the option premium.
Term
forward contract
Definition
Two parties agree that, at a set future date, one will perform and the other will pay a specified price for the performance. No option for nonperformance exists.
Term
futures contract
Definition
Commitment to buy or sell an asset at a fixed price during a specified future period; counterparty is unknown.
Futures are actively traded.
Term
mark-to-market
Definition
market price is posted and netted to each person's account at the close of every business day
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