Cpa Bec - Financial Risk Mgmt, Capital Budgeting

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Risk Neutral investor

Back 1

Disregards risk, preferes invetments with higher return

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Risk Seeking Investor

Back 2

Will seek high risk investment despite the fact that low rigk investment may provide same return

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Methods of estimating retun

Back 3

Arithmatic Average

Geomatric Average

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Arithmatic Ave. Return

Back 4

Computed by adding historical returns for a number of peirods and dividing by the # of periods

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Geomatric Ave. Return

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Componds annual retun earned by investors who bouthg the assets and held it for a number of historical periods examined.

Base of assets held for long periods

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Estimating Risk

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Similiar investment bell shaped/normal curve

+/- 2 Standard deviation

means 95% of return iwll fall within the 2 standard deviation

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Expected return of a portfolio

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E(Rp) = W1 E(R1) + W2 E(R2).....
Asset 1 = 60% of portfolio, 10% expected return
Asset 2 = 40% of portfolio, 5% expected return

(60% X 10% ) + (40% X 5%) = expected retun of the portfolio

Front 8

Variance of porfolio factors

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Covariance amonth the return or the ability to reduce the rosk of the portfolio by one asset

% of portfoliko invested in each asset

Variance of return on individual asset

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Unsystematic vs Systematic Risk

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Unsystematic risk can be diversified away

Systematic Risk can not be diversified away such as GDP, Inflation, Interest Rate

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Systematic Risk Measurement

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AKA Beta

Beta = Covariance of the investment / Protfolio Variance

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Business Riks/Interest Risk

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Credit/Default Risk
Interest Rate Risk
Market RIsk

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Credit/Default Risk

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the risk that a firm will default .
influenced by: Credit worthiness and Sector risk

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Interest Rate Risk

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The risk that the value of the bond will decline due to incresae in interest rate

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Market Risk

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the value will decline due to decline in the aggregate value of all assets in the market

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Stated Risk vs Effective Interest Risk

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Stated rate can compound more than annually which makes it a effective annual rate

EAR = (1 + r/m)M =1

M in the equaltion is square root
m =compunding frequency
r = rate

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Yield Curve

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Term structure of rate

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Normal Yield Curve

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Upward Slopping, short term is less than intermidiate, which is less than long term

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Inverted or Abnormal curve

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downward slopping

Short term > Intermidiate > long term

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Flat Yield curve

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Shorterm = Intermidiate = Long term rates

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Humped yield curve

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Intermidiate > short term + long term rates

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Liquidity Preference Theory

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long term rates has to be higher than short term rate to entice investor to hold less liquid and more price sensitive secquirities

interest rate go up, value of long term security goes down

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Market Segmentation Theory

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Demand for various term security depends on the demands of segmented group of investors

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Expectation Theory

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long tgerm rates tell us about short term rates

long term < short term market expecting short term to fall

long < short, inflation will fall

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Option - Derivatives

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Allow, not require the holder to buy/sell a specific standard commodity/Financial instrument. at a specific period of time or specific date

Buy = call
Put = sell

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Forward Derivatives

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Negotiated contract to purchase/Sell a specific quantity of a financial instrument, foreign currency or commodity at a price specified at origination of the contract with delivery and paymetn at a specific date

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Future contract

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forward based contract price specified at future date at market price

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Currency swaps

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Forward based contract, agree to exchange an obligation to pay cash flows in one currency for an obligation to pay in another currency

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Interest Rate swaps

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two parties agrees to swap stream of payment over a specified period of time

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Risk of using derivatives

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1. credit risk
2. Market Risk
3. Basis Risk
4. Legal Risk

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Fair Value hedge

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A hedge in the changes of a recognized assets/liablity or an unrecognized firm committment that are attributable to a particular risk

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Accounting of qualifying and designated hedge

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Fair Value - recognized in earning with offset to asset and liablity
Cash Flow hedge - Other comprehensive income, ineffective protion reported in earning

Foreign hedge: same as above

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Black School option pricing model

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1. Time to expiration of the option
2. Exercise/Srike price
3. risk free interest rate
4. Price of underlying stock
5. Volatility of price of underlying stock

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Valuation of bond

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Coupon rate = Fixed Rate

Coupon Rate < Market value then book value < Maturity value = discount

Coupon > Market price, book value > maturity value = premium

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Stages of capital budgeting

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1. Identification Stage
2. Search stage
3. Information- acquisition state
4. Selection stage
5. Financing stage
6. Implementation and control

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Capital Budgeting models

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1. Payback period
2. Accounting rate of return
3. Net present value
4. Excess present value index
5. Internal rate of return

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Limitation of payback method

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Ignores total project profitablity and time value of money

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Accounting rate of return

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Ignore time value of money

Annual Net Income (Before Dep/tax) / Ave initial investment

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Limitation of ARR

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Affected by depreciation method used

ignores present value of money

makes no adjsutment for project risk

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Internal rate of Return and NPV

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NPV > 0, IRR > Discount rate

NPV = 0, IRR = Discount rate

NPV < 0, IRR < Discount rate

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Coefficient of variation

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Standard diviation / Expected return

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the expected return of a protfolio is measured by the

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Weighted average

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A measure that describes teh risk of an investment project relative to other investment in general is teh

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Beta coefficient

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Short term interests are

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usually lower than long term rates

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Market price of a bond issues at a discoutn is the present value of its principal amount at market rate of interest

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Plus PV of future interest paymetn at the market rate of interest

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Captital budgeting techniques does not consider

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Depreciation expense or time value of money

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Accounting rate of return considers

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Revenue of life of the project and depreciation expnese

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NPV is effected by

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Proceeds from the slae of an asset to be replaced

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the level of risk that concerns investors who supply capital to a divesified compnay is

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Weighted average of project risk (betas)