Risk Management

Risk -The chance that an investment's actual return will be different than expected. Risk
includes the possibility of losing some or all of the original investment. Different versions of
risk are usually measured by calculating the standard deviation of the historical returns or
average returns of a specific investment. A high standard deviation indicates a high degree of
risk. But the best measure of risk is coefficient of variation

Types of risk
Asset-backed risk- Risk that the changes in one or more assets that support an asset-backed
security will significantly impact the value of the supported security. Risks include interest
rate, term modification, and prepayment risk.

Credit risk, also called default risk, is the risk associated with a borrower going into default
(not making payments as promised). Investor losses include lost principal and interest,
decreased cash flow, and increased collection costs. An investor can also assume credit risk
through direct or indirect use of leverage. For example, an investor may purchase an
investment using margin. Or an investment may directly or indirectly use or rely on repo,
forward commitment, or derivative instruments.

Foreign investment risk- Risk of rapid and extreme changes in value due to: smaller markets;
differing accounting, reporting, or auditing standards; nationalization, expropriation or
confiscatory taxation; economic conflict; or political or diplomatic changes. Valuation,
liquidity, and regulatory issues may also add to foreign investment risk.

Liquidity risk- This is the risk that a given security or asset cannot be traded quickly enough
in the market to prevent a loss (or make the required profit). There are two types of liquidity
risk:
Asset liquidity - An asset cannot be sold due to lack of liquidity in the market -
essentially a sub-set of market risk. s
Funding liquidity - Risk that liabilities: Cannot be met when they fall due, Can only be
met at an uneconomic price, Can be name-specific or systemic

Market risk- The four standard market risk factors are equity risk, interest rate risk, currency
risk, and commodity risk:
Equity risk is the risk that stock prices in general (not related to a particular company or
industry) or the implied volatility will change.
Interest rate risk is the risk that interest rates or the implied volatility will change.
Currency risk is the risk that foreign exchange rates or the implied volatility will change,
which affects, for example, the value of an asset held in that currency.
Commodity risk is the risk that commodity prices (e.g. corn, copper, crude oil) or implied
volatility will change.

Operational risk is "the risk of a change in value caused by the fact that actual losses, incurred
for inadequate or failed internal processes, people and systems, or from external events
(including legal risk), differ from the expected losses".
 Bill Broodiest, star quarterback for the Spring Bay Smashers, would like to invest a small
portion of his earnings in stocks of one of three firms. His estimated returns and the
probabilities of their occurrence follow.

a) Calculate the expected return for each stock.

b) Calculate the coefficient of variation for each stock.
c) Rank the three from the least risky to the most risky.
d) Which stock would you recommend to Bill?

Multiple Choice

1. The type of risk that is not diversifiable and affects the value of a portfolio is
A. Purchasing-power risk
B. Nonmarket risk
C. Interest-rate risk
D. Market risk

2. When purchasing temporary investments, which one of the following best describes the
risk associated with the ability to sell the investment in a short period of time without
significant price concessions?
A. Liquidity risk
B. Interest-rate risk
C. Purchasing power risk
D. Financial risk

3. The risk that securities cannot be sold at a reasonable price on short notice is called
A. Liquidity risk
B. Default risk
C. Purchasing-power risk
D. Interest-rate risk

4. Political risk may be reduced by

A. Entering into a joint venture with another foreign company
B. Making foreign operations dependent on the domestic parent for technology, markets,
and supplies.
C. Financing with capital from a foreign country
D. Refusing to pay higher wages and higer taxes

5. The risk of loss because of fluctuations in the relative value of foreign currencies is called
A. Undiversifiable risk
B. Exchange rate risk
C. Expropriation risk
 D. Multinational beta

6. Prior to the introduction of euro, O & B Company, a US corporation, is in possession of

accounts receivable denominated in Deutsche marks. To what type of risk are they exposed?
A. Exchange-rate risk
B. Business risk
C. Liquidity risk
D. Price risk

7. An investment security with high risk will have a(n)

A. High standard deviation of returs
B. Increasing expected rate of return
C. Low expected rate of return
D. Lower price than an asset with low risk

8. Catherine & Co. Has extra cash at the end of the year and is analyzing the best way to
invest the funds. The company should invest in a project only if the
A. Expected return on the project is equal to the return on investment of comparable risk
B. Expected return on the project exceeds the return on investments of comparable risk.
C. Return on investment of comparable risk equals the expected return on the project
D. Return on investments of comparable risk exceeds the expected return on the project.

9. The marketable securities with the least amount of default risk are
A. Commercial paper
B. Repurchase agreement
C. Treasury securities

10. Which of the following classes of securities are listed in order from lowest
risk/opportunity for return to highest risk/opportunity for return
A. Treasury bonds, corporate first mortgage bonds, corporate income bonds, preferred
stock
B. Corporate income bonds, corporate mortgage bonds, convertible preferred stock,
subordinated debentures
C. Preferred stock, common stock, corporate mortgage bonds, corporate debentures
D. Common stock, corporate first mortgage bonds, corporate second mortgage bonds,
corporate income bonds.

11. From the viewpoint of the investor, which of the following securities provides the least
risk?
A. Income bonds
B. Debentures
C. Subordinated debenture
D. Mortgage bond

12. An investor is currently holding income bonds, debentures, subordinated debentures, and
first-mortgage bonds. Which of these securities traditionally is considered to have the least
risk?
A. Subordinated debentures
B. First-mortgage bonds
C. Income bonds
D. Debentures
13. Joe Co’s financial analysis department has estimated a proposed investment with the
following rate of return distributions.
Rate of Return Probability
(5%) 30%
10% 50%
20% 20%

Calculate the expected rate of return

A. 11.7% B. P5.5% C. 7.5% D. 10.5%

14. Russell Co. is evaluating our independent investment proposals. The expected returns and
standard deviations for each of these proposals are presented below
Investment Expected Return Standard Deviation
I 16% 10%
II 14% 10%
III 20% 11%
IV 22% 15%

Which of the investment proposals has the least relative level of risk?
A. IV
B. III
C. II
D. I

15. The expected rate of return for the stock of Colt Co is 20%, with a standard deviation of
15%. The expected rate of return for the stock of Mustang Co is 10%, with a standard
deviation of 9%. The riskier stock is
A. Mustang because the standard deviation is higher
B. Colt becuase the return is higher
C. Colt because the standard deviation is higher
D. Mustang because the coefficient of variation is higher

16. A feasible portfolio that offers the highest expected return for a given risk or the least risk
for a given expected return is
A. Optimal portfolio
B. Efficient portfolio
C. Desirable portfolio
D. Effective portfolio

17. The risk of a single stock is

A. Portfolio risk
B. Security risk
C. Interest rate risk
D. Market risk

18. The measure that describes the risk of an investment project relative to other investments
in general is the
A. Beta coefficient
B. Standard deviation
C. Coefficient of variation
D. Expected return

19. A company holds the following stock option

Stock Portfolio % of Total Beta Coefficient
W 20% 0.8
X 40% 0.6
Y 30% 1.0
 Z 10% 2.0

The beta of the portfolio is

A. 0.9
B. 1.1
C. 2.0
D. 8.0

20. The difference between the required rate of return on a given risky investment and that on
a riskless investment with the same expected return is the
A. Risk premium
B. Coefficient of variation
C. Beta coefficient
D. Standard deviation

21. Macedonia Oil is drilling an offshore oil well. The following table lists the expected cash
flow from each possible outcome and, based on geological studies, the probability of each.
Outcome Cash Flow Probability
Dry Well -P1,000,000 0.30
Natural Gas 1,000,000 0.30
Gas and Oil 2,000,000 0.20
Oil 1,000,000 0.20

Each cash flow will occur one year from today and will fully deplete the well. There is a cash
outflow for a dry well due to shutdown expenses. Calculate the expected value of the cash
flows from the well, and the standard deviation and coefficient of variation of the cash flows.
a. P1,000,000; P600,000; 1.537
b. P766,000; P1,512,250; 1.966
c. P600,000; P1,113,553; 1.856
d. P650,000; P1,211,353; 1.812

22. You have two assets in your investment portfolio: a stock mutual fund with a beta of 1.20
and U.S. treasury securities (assume that they are risk-free). What is the beta of your portfolio
if 40% of your funds are invested in the treasury securities?
a. 0.60
b. 0.40
c. 0.81
d. 0.72