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CMA - Financial Decision Making > Managing Financial Risk > Flashcards

Flashcards in Managing Financial Risk Deck (16)
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1
Q

What is Business risk?

A

Business risk is the risk of an adverse outcome based on a change in the firm’s particular context (i.e. changes in input prices, consumer tastes and regulatory environment)

2
Q

How does operating leverage relate to business risk?

A

Operating leverage relates directly to business risk. The degree of a firm’s operating leverage increases as it uses more fixed costs in its ongoing operations

A firm with high operating leverage necessarily carries a greater degree of risk because fixed costs must be covered regardless of the level of sales. However, such a firm is also able to expand production rapidly in times of higher product demand

Thus, the more leveraged a firm is in its operations, the more sensitive operating income is to changes in input prices, consumer tastes and the regulatory environment

3
Q

What is Financial risk?

A

Financial risk is the risk of an adverse outcome based on a change in the financial markets (i.e. changes in interest rates and investors’ desired rates of return)

4
Q

How does financial leverage relate to financial risk?

A

Financial leverage relates directly to financial risk. The degree of a firm’s financial leverage increases as it uses more fixed costs (i.e. debt and preferred stock) in its financial structure

A firm with high financial leverage necessarily carries a greater degree of risk because debt must be serviced regardless of profits. However, if such a firm is profitable, there is more residual profit for the shareholders after debt service (interest on debt is tax-deductible), reflected in higher earnings per share. Furthermore, debt financing permits the current equity holders to retain control

Thus, the more leveraged a firm is in its financing, the more sensitive net income is to changes in interest rates and desired rates of return

5
Q

What is considered to be an efficient portfolio?

A

An investor wants to maximize return and minimize risk when choosing a portfolio of investments. A feasible portfolio that offers the highest expected return for a given risk or the least risk for a given expected return is an efficient portfolio

A portfolio that is selected form the efficient set of portfolios because it is tangent to the investor’s highest indifference curve is the optimal portfolio

6
Q

What is an Indifference curve?

A

An indifference curve represents combinations of portfolios having equal utility to the investor. Given that risk and returns are plotted on the horizontal and vertical axes, respectively and that the investor is risk adverse, the curve has an increasingly positive slope

As risk increases, the additional required return per unit of additional risk also increases

The steeper the slope of an indifference curve, the more risk adverse an investor is

The higher the curve, the greater the investor’s level of utility

7
Q

What are the most important decisions in managing a company’s portfolio?

A

Two important decisions are involved in managing a company’s portfolio:

  1. The amount of money to invest
  2. The securities in which to invest

The investment in securities should be based on expected net cash flows and cash flow certainty evaluations

8
Q

In managing a company portfolio, how should the average return returns be maximized?

A

Arranging a portfolio so that the maturity of funds will coincide with the need for funds will maximize the average return on the portfolio and provide increased flexibility

Maturity matching ensures that securities will not have to be sold unexpectedly

9
Q

In managing a company portfolio, what should be done if cash flows are uncertain>

A

If its cash flows are relatively uncertain, a security’s marketability and market risk are important factors to be considered. Transaction costs are also a consideration

Higher-yield long-term securities provide less certainty

When cash flows are relatively certain, the maturity date becomes the most important concern

10
Q

What is hedging?

A

Hedging is the process of using offsetting commitments to minimize or avoid the impact of adverse price movements

Hedging transactions are often used to protect positions in:

  1. Commodity buying
  2. Foreign currency
  3. Securities
11
Q

What are long hedges?

A

Long hedges are futures contracts that are purchased to protect against price increases

12
Q

What are short hedges?

A

Short hedges are futures contracts that are sold to protect against price declines

13
Q

In hedging commodities, how is leverage beneficial to the parties of the contract?

A

Since commodities can be bought and sold on margin, considerable leverage is involved. Leverage is most beneficial to the speculator who is seeking large returns and is willing to bear proportionate risk

For hedgers, however, the small margin requirement is useful only because the risk can be hedged without tying up a large amount of cash

14
Q

What is a natural hedge?

A

A natural hedge is a method of reducing financial risk by investing in two different items whose performance tends to cancel each other. A natural hedge is unlike other types of hedges in that it does NOT require the use of sophisticated financial tools (such as derivatives). However, natural hedges are not perfect in that they do not eliminate all risk

Buying insurance is a natural hedge

Pair trading is a type of natural hedge. Pair trading involves buying long and short positions in highly correlated stocks

Investing in both stocks and bonds is sometimes viewed as a natural hedge, since the performance of one offsets the other

15
Q

What are Interest rate futures contracts?

A

Interest rate futures contracts involve risk-free securities (i.e. Treasury bonds, T-bills and money market certificates)

By engaging in this type of hedge, a financial manager need not worry about fluctuations in interest rates, but can concentrate instead on the day-to-day operations of the company

16
Q

What is Duration hedging?

A

Duration hedging involves hedging interest-rate risk. Duration is the weighted average of the periods of time to interest and principal payments. If duration increases, the volatility of the price of the debt instrument increases

The goal of duration hedging is NOT to equate the duration of assets and the duration of liabilities, but the following relationship to apply:

(Value of assets) x (Duration of assets) = (Value of liabilities) x (Duration of liabilities)

Note: Assets have positive duration number and liabilities have negative numbers. If the duration is positive, then we are exposed to rising interest rates. If duration is negative, we are exposed to falling interest rates