RISK MANAGEMENT- Final Exam

Accept risk.

Recognizing that  undertaking  certain risky  activities should  generate  shareholder  value.

Agency risk.

The board also needs to be on the alert for any conflict that may arise between the interests of management to assume risks and the interests of the company’s stakeholders.

Arbitrage Pricing Theory.

Is a multifactor model, whereby several different indices can be used to explain the variation in expected rates of return.

Avoid risk.

By  choosing not  to undertake  some  activities.

Beta.

Is a measure of the covariance between that asset’s return and the return on the market, divided by the market’s variance.

Beta.

Represents that portion of an asset’s total risk that cannot be neutralized by diversification in a portfolio of risky assets, and for which some compensation must be demanded.

Business Unit Manager.

Responsible for risk and performance of the business. Must ensure limits are delegated to traders.

Call.

An option to buy the asset is referred to.

Capital Asset Pricing Model (CAPM).

Sharpe and Linter made the assumption that investors can choose to invest in any combination of a risk-free asset and a “market portfolio” that includes all the risky assets in an economy.

Chief Risk Officer (CRO).

Responsible for independent monitoring of limits. May order positions reduced for market, credit, or operational concerns. Reserve (say 10%); Delegates Risk to Heads of Business.

Conflicts of interest.

Can easily happen if, for example, executives are rewarded with options that they can cash in if the share price of the company rises above a certain level for a short time.

Credit-risk limits.

Serve to control and limit the number of defaults as well as limiting a downward migration in the quality of the credit portfolio (e.g., the loan book).

First wave.

These scandals included, most notoriously, the failure of energy giant Enron in 2001, a wave of “new technology” and telecom industry accounting scandals at companies like WorldCom and Global Crossing, and, to prove that the problem wasn’t confined to the United States, the collapse of the Italian dairy products giant Parmalat in late 2003.

Focus | Cost-Volume-Profit analysis.

Focuses on how profits are affected by the following five factors: Selling prices, Sales volume, Unit variable costs, Total fixed costs, Mix of products sold.

Four basic choices in risk management.

Avoid, Mitigate, Transfer, Accept.

Heads of Business.

Share responsibility for risk of all trading activities. Delegates to Business Unit Manager.

Herding behavior.

Which describes the tendency to mimic the investment behavior of large groups.

Market Risk Premium.

Simply the difference between the expected rate of return on the risky market portfolio and the risk-free rate.

Market-risk limits.

Serve to control the risk that arises from changes in the absolute price (or rate) of an asset.

Mental accounting.

Which explains how investors tend to divide their investments into separate mental accounts based on criteria such as the source of funds or the use of funds.

Mitigate risk.

Such as  operational risk,  through  preventive and  detective control  measures.

Options.

Are financial assets that entitle their holders to purchase or sell another asset by or on a predetermined day, at a predetermined price, called the striking price.

Ostrich effect.

Describes how many investors do not seem to want to see risky situations and are willing to accept a lower return for identical risk if they are not presented with the risky situation.

Put.

While an option to sell the asset is called like that.

Risk committee of the board.

Approves market-risk tolerance each year. Delegates authority to senior risk committee.

Risk-sensitive.

Measures such as VaR are good at expressing risk in normal market conditions and for most kinds of portfolios, but less good in extreme circumstances or for specialized portfolios (e.g., certain kinds of option portfolios).

Second wave.

A series of bankruptcies and near bankruptcies of large financial institutions between 2007 and 2009; In particular, the risk management function of many companies failed to attract the attention of senior management or boards of directors to the risk built up in structured financial products. One of the reasons may have been a process of marginalization of the role of risk management.

Senior risk committee.

Delegates authority to CRO. Step 1: Approves market risk tolerance, stress and performance limits each year; reviews business unit mandates and new business initiatives. Step 2: Delegates authority to the CRO and holds in reserves; additional authority approved by the risk committee of the board.

Transfer risk.

To  third parties  through  insurance,  hedging, and  outsourcing.

True risk governance.

The primary responsibility of the board is to ensure that it develops a clear understanding of the bank’s business strategy and the fundamental risks and rewards that this implies. The board also needs to make sure that risks are made transparent to managers and to stakeholders through adequate internal and external disclosure.

Value at- risk (VaR).

Measures for market risk and credit risk or potential exposure limits by risk grade for credit risk.

Cost-Volume-Profit analysis.

Is a powerful tool that helps managers understand the relationships among cost, volume, and profit.

Contribution margin.

Is the amount remaining from sales revenue after variable expenses have been deducted.

Function | Contribution Margin.

Is the amount available to cover fixed expenses and then to provide profits for the period.

Target profit analysis.

We estimate what sales volume is needed to achieve a specific target profit.

Margin of safety.

Is the excess of budgeted or actual sales dollars over the break even volume of sales dollars.

Variable costing.

Are only those manufacturing costs that vary with output are treated as product costs. This would usually include direct materials, direct labor, and the variable portion of manufacturing overhead.

Common fixed cost.

Is a fixed cost that supports the operations of more than one segment, but is not traceable in whole or in part to any one segment.

Break-even point.

Is the level of sales at which profit is zero.

Break-even point.

Is the level of production at which the sales profit is exactly equal to the sum of the fixed and variable costs.

Internal rate of return method.

When using this method to rank competing investment projects, the preference rule is: the higher the internal rate of return, the more desirable the project.

Present value.

Is the present value of $ pesos of a future amount. The amount of money that would need to be invested today at a given interest rate during a specified period to obtain the future amount.

Net Present Value.

This is a complex capital budgeting technique, calculated by subtracting a project's initial investment from the present value of its discounted cash inflows at a rate equal to the company's cost of capital.

Payback method.

Focuses on the payback period.

Payback period.

Is the length of time that it takes for a project to recover its initial cost from the net cash inflows that it generates. This period is sometimes referred to as “the time that it takes for an investment to pay for itself.” 

Pessimistic

when the WACC is higher than the CAPM

Optimistic

when the WACC is lower than the CAPM

Weighted average cost of capital (WACC)

The discount rate used to discount future cash flows when valuing an investment project.