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FSM
Finance Skills for Managers Unit 2
| Question | Answer |
|---|---|
| What is an interest rate? | The percentage a lender charges a borrower for the use of money, usually expressed as APR. |
| How does an interest rate function? | Like a rental fee for borrowed money. |
| What is APR? | Annual Percentage Rate—how interest is expressed annually. |
| Why do interest rates matter in finance? | They influence borrowing and saving decisions and affect financial planning. |
| Name three common uses of interest rates in everyday life. | Loans, savings/checking accounts, and investments. |
| How do interest rates affect loans? | Higher rates increase the cost of borrowing. |
| How do interest rates affect savings? | Higher rates increase the return on savings. |
| What is the formula for simple interest? | Annual Interest = Principal × Interest Rate |
| How is total simple interest calculated? | Total Interest = Annual Interest × Time (years) |
| What is compound interest? | Interest calculated on both the principal and previously earned interest. |
| What is the formula for compound interest? | Total = Principal × (1 + Rate)ⁿ − Principal |
| Which grows faster: simple or compound interest? | Compound interest. |
| Give a simple vs. compound interest example: $100 at 10% for 2 years. | Simple = $20, Compound = $21 |
| What is the monthly interest rate if APR is 4.5%? | 0.375% (4.5% ÷ 12) |
| How much interest is charged in the first month of a $200,000 mortgage at 4.5%? | $750 |
| What are the two main parts of a mortgage payment? | Interest and principal. |
| What is the Discount Rate? | The rate used in time value of money calculations. |
| What is the Required Rate of Return? | The return expected by a lender or investor. |
| What is the Cost of Capital? | The cost a business incurs to raise funds through borrowing. |
| Why is understanding interest rates important? | It helps with personal finance, business decisions, and investment planning. |
| What is the term for the percentage of the principal that a lender charges a borrower for the use of assets? | Interest rate |
| How is the interest rate expressed? | As a percentage |
| What is the main purpose of charging interest? | It allows borrowers to pay to use the assets of another entity to accomplish their own goals. |
| What is the required rate of return? | The minimum return an investor or lender expects to justify taking on risk. |
| What is another name for the required rate of return in corporate finance? | The hurdle rate. |
| Why is the required rate of return important? | It helps investors decide whether an investment is worth the risk. |
| What happens if a project’s expected return is below the required rate? | The investment is typically rejected. |
| What happens if a project’s return exceeds the required rate? | The investment is considered acceptable. |
| What is opportunity cost? | The return you miss by not choosing the next best alternative. |
| How does opportunity cost affect investment decisions? | Investors won’t accept lower returns if better options are available. |
| What is risk in the context of required return? | The possibility that actual returns will be lower than expected. |
| How does risk influence the required rate of return? | Higher risk leads to a higher required return. |
| Why is getting paid now considered less risky than getting paid later? | There’s more uncertainty in receiving future payments. |
| How does inflation factor into required return? | It reduces the value of money over time, so investors need higher returns to compensate. |
| What is an example of how inflation affects investment value? | If inflation is 2%, $1,000 next year is worth less than $1,000 today. |
| What are the three components of the required rate of return? | Opportunity cost, risk, and inflation. |
| In the print shop example, what is the opportunity cost? | An 8% return from hiring night-shift workers instead of buying a printer. |
| What is the risk in the print shop scenario? | Overestimating demand or an economic slowdown. |
| What is the inflation expectation in the print shop example? | Costs and wages expected to rise by 2–3%. |
| When would the print shop proceed with the printer investment? | Only if the expected return exceeds combined costs from opportunity cost, risk, and inflation. |
| What do large public companies use to calculate their required return? | Cost of capital, which includes opportunity cost, risk, and inflation. |
| What should be done if an investment doesn’t meet the required rate of return? | It should likely be avoided. |
| Why is understanding the required return essential in finance? | It ensures resources are invested efficiently and risks are properly rewarded. |
| What is a component of the required rate of return? | Opportunity cost |
| Why would a long-term investment require a higher rate of return? | There is greater risk involved and a higher opportunity cost. |
| What is inflation? | The rate at which the average price level of goods and services increases over time. |
| What is the impact of inflation on money? | It reduces purchasing power—money buys less in the future. |
| Give an example of inflation’s impact using $1,000. | $1,000 in 2010 could buy more than $1,000 today. |
| What are the three main causes of inflation? | Increased demand, rising costs, and built-in (adaptive) inflation. |
| What is demand-pull inflation? | Inflation caused when demand exceeds supply. |
| Give an example of demand-pull inflation. | Airline tickets cost more during holidays due to high demand and limited seats. |
| What is cost-push inflation? | Inflation caused by increased costs of production inputs like fuel or labor. |
| Example of cost-push inflation? | Rising oil prices increase transportation costs, which raise airline fares. |
| What is built-in inflation? | A cycle where rising prices lead to wage demands, which then lead to more price increases. |
| How do regulations and tariffs contribute to inflation? | They increase business costs, which are passed on to consumers. |
| How can technology reduce inflation? | By lowering production costs and increasing efficiency. |
| Give a historical example of technology reducing costs. | Ford’s assembly line cut car assembly time from 12 hours to under 3, lowering prices. |
| Why do modern cars cost more despite tech advancements? | Advanced features, higher wages, and costlier materials. |
| What was the price of a car in 1916, and what is its inflation-adjusted cost? | $360 in 1916 ≈ $7,953 today, but actual price ≈ $37,401 in 2019. |
| What was the average U.S. family income in 1950? | $3,300. |
| What was the average U.S. family income in 2016? | About $59,000. |
| What is the overall definition of inflation? | A general rise in prices and a decline in the purchasing power of money. |
| Can technology completely eliminate inflation? | No, it can reduce its effects but not eliminate it. |
| What are four major contributors to inflation? | Consumer demand, input costs, wage expectations, and government regulations/tariffs. |
| Why is understanding inflation important? | It affects budgeting, saving, investing, and long-term financial planning. |
| Why is built-in inflation linked to adaptive expectations? | Workers want higher wages to keep their standard of living as prices increase, which pushes the prices even higher. |
| Why does an increased demand for goods and services cause inflation? | An increase in demand often causes an insufficient supply in the market, which causes prices to go up until the demand is once again equal to the supply. |
| What happens to prices in a market in which there is inflation? | Prices rise. |
| What are the three components of interest rates? | Opportunity cost, risk, and inflation. |
| What is the formula for interest rate? | Interest Rate = Risk-Free Rate + Risk Premium |
| What is the risk-free rate? | A return that includes inflation and opportunity cost, often represented by U.S. Treasury bonds. |
| What is a risk premium? | The extra return required to compensate for risk. |
| Give an example of calculating risk premium. | Ford Bond Rate = 5.70%, Treasury Rate = 1.73%, Risk Premium = 3.97% |
| What is the nominal interest rate? | The total return including inflation. |
| What does the nominal rate tell you? | How much money you will have, but not its purchasing power. |
| What is the real interest rate? | The return after adjusting for inflation; reflects actual purchasing power. |
| How do you calculate the real interest rate? | Real Rate = Nominal Rate − Inflation Rate (Fisher Effect) |
| Example: If nominal rate = 5% and inflation = 2%, what is the real rate? | Real Rate = 5% − 2% = 3% |
| Why is the real rate important? | It shows the true increase in your purchasing power. |
| What does the Fisher Effect describe? | The relationship: Real Rate = Nominal Rate − Inflation Rate |
| If inflation is 8% and nominal return is 10%, what’s the real gain? | 2% |
| CD Example: 5-year CD earns 2.50%, inflation is 2.00%—what is the real rate? | 0.50% real growth in purchasing power. |
| What kind of investments need higher returns? | Longer-term investments (to offset inflation and risk). |
| How does your credit score affect interest rates? | A strong credit score leads to lower interest rates, since you're seen as a safer borrower. |
| What should you use to compare investment options? | The real interest rate. |
| What does the nominal rate fail to show? | The actual value of your money after inflation. |
| Why is using the real rate better for financial decisions? | It accounts for inflation and shows true gains in purchasing power. |
| What is the compensation for risk given to investors called? | Risk premium |
| Which type of interest rate is the rate at which invested money grows for a certain period time? | Nominal rate |
| Which component of an interest rate is an indicator of inflation and opportunity cost? | Risk-free rate |
| What is the name for the interest rate expressed on an annual basis? | Annual percentage rate |
| Why is the required rate of return also known as the hurdle rate? | It is the minimum rate that a firm must surpass to accept a project. |
| What is the inflation rate? | The rate at which the average price level of a basket of goods and services in an economy increases |
| What does the risk-free rate indicate? | Inflation and opportunity cost |
| What is the name for a series of equal payments made at the end of consecutive periods over a fixed length of time? | Ordinary annuity |
| If you invest $10,000 today and then $5,000 each year for the next 5 years into an investment with an interest rate of 4%, you can withdraw $39,248.14 in 5 years. What does $39,248.14 represent? | Future value |
| What is the name for the concept that a dollar today is worth more than a dollar in the future? | Time value of money |
| What does the Time Value of Money (TVM) concept state? | A dollar today is worth more than a dollar in the future due to inflation, risk, and opportunity cost. |
| What are the three reasons money loses value over time? | Inflation, risk, and opportunity cost. |
| What is Present Value (PV)? | The value today of money you’ll receive in the future. |
| What is Future Value (FV)? | The value in the future of money you have or invest today. |
| What is compounding? | The process of calculating future value from present value. |
| What is discounting? | The process of calculating present value from a future amount. |
| What are the key variables in TVM calculations? | Cash flow amount, timing of cash flows, and interest rate. |
| What is an annuity? | A series of equal payments made at regular intervals. |
| What is an ordinary annuity? | Payments made at the end of each period (e.g., car loan). |
| What is an annuity due? | Payments made at the beginning of each period (e.g., rent). |
| What is a perpetuity? | Equal payments made forever (e.g., preferred stock). |
| Example: What is the FV of $5,000 today in 10 years? | $10,000 (assuming 100% return over 10 years). |
| Example: What is the PV of $10,000 in 2 years at 2.5% inflation? | $9,518.14 |
| What Excel function calculates the present value? | =PV(rate, nper, pmt, [fv], [type]) |
| What Excel function calculates the future value? | =FV(rate, nper, pmt, [pv], [type]) |
| What Excel function calculates the payment amount? | =PMT(rate, nper, pv, [fv], [type]) |
| What Excel function calculates net present value? | =NPV(rate, value1, [value2], …) |
| When using Excel, what should you do if payments are monthly? | Divide the interest rate by 12 and multiply years by 12 for nper. |
| What is the FV of saving $500/month for 30 years at 8% interest? | $745,179.72 |
| Example: Invest $10,000 today + $5,000/year for 5 years at 4%. What does $39,248.14 represent? | The future value of the investment. |
| What is the name for a series of equal payments made at the end of consecutive periods over a fixed time? | Ordinary annuity. |
| Why is $100 today more valuable than $100 in 10 years? | Due to inflation, risk, and opportunity cost. |
| What is the FV of a home priced at $100,000 today with 5% annual growth for 5 years? | $127,628.16 |
| What was the PV of a $100,000 home 30 years ago at 5% annual growth? | $23,137.74 |
| What does TVM help you do in finance? | Evaluate and compare the value of cash flows at different times for smarter decisions. |
| What does TVM stand for? | Time Value of Money. |
| What is the core idea behind TVM? | Money today is worth more than the same amount in the future due to inflation, risk, and opportunity cost. |
| Why is TVM important in financial decision-making? | It helps compare the true value of money over time, ensuring smarter financial choices. |
| How do businesses use TVM? | To evaluate investment and financing decisions based on future cash flows and present costs. |
| What is the purpose of using a discount rate in business finance? | To assess the cost of capital needed to attract investors and account for risk. |
| Business Example: What if a project costs $300,000 and returns $100,001/year for 3 years? | Face value profit is $3, but TVM shows future cash flows are worth less today. |
| Why is it incorrect to directly compare future and present cash flows? | Because future money loses value due to inflation and risk—TVM adjusts for this. |
| How does TVM apply to personal finance? | It affects decisions like mortgages, loans, and retirement savings by highlighting long-term costs and benefits. |
| Mortgage Example: Which costs more overall—a 20-year or 30-year mortgage? | The 30-year mortgage, due to longer time and higher interest. |
| 20-year mortgage details at 3.00% interest on $360,000 loan? | Monthly: $1,996.55; Total paid: $479,172.32; Interest: $119,172.32. |
| 30-year mortgage details at 3.50% interest on $360,000 loan? | Monthly: $1,616.56; Total paid: $581,961.92; Interest: $221,961.92. |
| Key point when choosing loan terms? | Shorter terms = higher monthly payments but lower total interest paid. |
| Retirement Example: Want $50,000/year for 20 years starting at age 65. Start saving at age 30 with 5% return—how much monthly? | $968.23/month. |
| What if saving starts at age 45 instead of 30? | $2,676.18/month—much more due to shorter time and lost compounding. |
| What does TVM teach about early investing? | Starting earlier dramatically lowers the amount needed to save each month. |
| What factors influence the total cost or value of a financial decision? | Time, interest rate, and inflation. |
| Why is TVM important for retirement planning? | It helps estimate future needs and create realistic saving strategies. |
| What does TVM allow you to do with cash flows? | Accurately compare their value across different time periods. |
| What is a key financial insight from TVM in both business and personal decisions? | The earlier you act, the more value you can preserve or grow. |
| You are considering purchasing a house for $250,000. You have two options to finance it. One is a 20-year mortgage with an interest rate of 3.5%, and the other is a 30-year mortgage with an interest rate of 3.5%. Which mortgage option requires you to pay | A 30-year mortgage |
| Why does the time value of money play an important role in financial decision-making? | Because the benefits of investments received at different times are comparable only when you consider the time value of money |
| What are the four key TVM calculations covered in Excel? | Present Value (PV), Future Value (FV), Net Present Value (NPV), and Internal Rate of Return (IRR). |
| What is the formula for Future Value (FV) of a single sum? | FV = PV × (1 + i)ⁿ |
| What is the Excel function for FV? | =FV(rate, nper, pmt, pv, type) |
| Example: What is the FV of $100 invested at 6% for 2 years? | $112.36 |
| What is the formula for Present Value (PV) of a single sum? | PV = FV / (1 + i)ⁿ |
| What is the Excel function for PV? | =PV(rate, nper, pmt, fv, type) |
| Example: What is the PV of land worth $50,000 in 5 years at 3%? | $43,130.44 |
| What does rate represent in Excel TVM functions? | Interest rate per period |
| What does nper represent in Excel TVM functions? | Number of periods |
| What does pmt represent in Excel TVM functions? | Payment per period (use 0 for single sum calculations) |
| What does type represent in Excel functions? | 0 = end of period (ordinary), 1 = beginning (annuity due) |
| What is an ordinary annuity? | Equal payments made at the end of each period. |
| Excel FV example: $1,000/year for 3 years at 8% (ordinary annuity)? | $3,246.40 |
| Excel PV example: Withdraw $1,000/year for 3 years at 8% (ordinary)? | $2,577.10 |
| What is an annuity due? | Equal payments made at the beginning of each period. |
| What do you set type to in Excel for annuity due? | 1 |
| Excel FV of annuity due: $1,000/year for 3 years at 8%? | $3,506.11 |
| Excel PV of annuity due: $1,000/year for 3 years at 8%? | $2,783.26 |
| How do you adjust rate and nper for monthly payments? | Rate ÷ 12, Years × 12 |
| Example: $300/month for 20 years at 6% → FV? | $138,612.27 |
| Example: $200/month for 5 years at 4.8% → PV? | $10,649.77 |
| What is a perpetuity? | A series of equal payments that continue forever. |
| What is the formula for PV of a perpetuity? | PV = PMT ÷ Rate |
| Example: $10,000 annually at 8% → PV of perpetuity? | $125,000 |
| What is the "3 find 4" tip for solving TVM problems? | Input any 3 variables to solve for the 4th. |
| What sign convention should you use in Excel TVM functions? | Negative for outflows (payments), positive for inflows (receipts) |
| What does Excel function =NPV(rate, value1, [value2], …) calculate? | Net Present Value of a series of cash flows. |
| What does Excel function =IRR(values, [guess]) calculate? | Internal Rate of Return for a series of cash flows. |
| What are the advantages of using Excel for TVM? | Speed, accuracy, and ability to repeat complex calculations. |
| You are calculating the present value of an annuity due of $5,000 a year for 20 years. The discount rate is 3%. What should be the “type” input variable of the PV function? | 1 |
| You are calculating the future value of an ordinary annuity. You are planning to save $1,000 a year for the next 10 years in an account that gives a 3% interest rate. You set up an Excel sheet as follows: Rate is 3%, nper is 10, pmt is -1000, type is 0 pv | =FV(C2,C3,C4,C5,C6) |
| You are calculating the lump sum of money needed now in order to withdraw $10,000 a year over the next 5 years from an account that earns a 3% interest rate. Which Excel function should you use? | PV function |
| What does the Excel =PMT() function calculate? | Equal periodic payments (annuity payments). |
| What is the syntax for =PMT() in Excel? | =PMT(rate, nper, pv, [fv], [type]) |
| PMT Example: How much must you invest annually to reach $50,000 in 10 years at 5% starting with $5,000? | $3,327.71 per year. |
| What does the Excel =RATE() function calculate? | The interest rate or rate of return. |
| What is the syntax for =RATE() in Excel? | =RATE(nper, pmt, pv, fv, [type]) |
| RATE Example: Buy stock at $3.54, sell at $21.54 in 5 years—what is the return? | 43.5% annual return. |
| What does the Excel =NPER() function calculate? | The number of periods needed for a financial goal. |
| What is the syntax for =NPER() in Excel? | =NPER(rate, pmt, pv, fv, [type]) |
| NPER Example: $11,463.88 account balance, $1,000/year, 3% rate—how many years? | 10 years. |
| How do you adjust rate and nper for monthly calculations? | Rate ÷ 12 and NPER × 12 |
| What is the Excel function for Net Present Value (NPV)? | =NPV(rate, value1, [value2], …) |
| What does =NPV() calculate? | Present value of uneven cash flows. |
| NPV Example: 5 cash flows ($3,500, $4,000, $4,200, $4,500, $4,600) at 6%—what is the NPV? | $17,390.08 |
| What does NPV represent in investment terms? | The maximum you should pay for the investment today. |
| What does the Excel =IRR() function calculate? | The internal rate of return (IRR) for uneven cash flows. |
| What is the syntax for =IRR() in Excel? | =IRR(values, [guess]) |
| IRR Example: Initial investment = $15,000, cash flows = same as NPV example—what’s the IRR? | 11.42% |
| What’s the rule for using signs in Excel cash flow functions? | Use negative for cash outflows and positive for cash inflows. |
| What does =PMT() help you do in real life? | Plan regular savings or loan payments. |
| What does =NPER() help you understand? | How long you must save or pay to meet a goal. |
| Why are NPV and IRR useful for uneven cash flows? | They help evaluate real-world investments that don’t have consistent returns. |
| What kind of investments require NPV and IRR rather than PV/FV? | Projects or assets with uneven or non-periodic cash flows. |
| What is a key use of =RATE()? | Estimating return on investments when you know initial and final values. |
| What does IRR tell you about a project? | The expected annual rate of return. |
| What’s the purpose of mastering PMT, RATE, NPER, NPV, and IRR in Excel? | To make data-driven financial decisions with time value of money principles. |
| Which Excel function should you use when you are finding a present value of uneven cash flows to find the PV in one step? | NPV |
| Which Excel function should be input to cell C5 to find the interest rate of the following cash flows? Assume the discount rate is 12%. Year 1 is $1,000. | =IRR(b3:e3) |
| What is a return? | The gain or loss on an investment over time. |
| In what forms can return be expressed? | In dollars, percentages, or annualized returns. |
| What is Holding Period Return (HPR)? | The total return earned during the time an investment is held. |
| What components are included in HPR? | Capital gains and cash flows like dividends. |
| What is the formula for Holding Period Return (HPR)? | HPR = [(Ending Price – Beginning Price + Dividends) ÷ Beginning Price] × 100 |
| HPR Example: Buy at $42, sell at $43, $2 dividend — what’s the return? | 7.14% |
| How do you annualize a return? | Annualized Return = HPR × (360 ÷ days held) |
| Annualizing Example: 3-month return of 7.14% — what’s the annualized return? | 28.57% |
| What is Expected Return? | A forecasted return based on possible outcomes and their probabilities. |
| What is the formula for Expected Return? | Expected Return = Σ (Probability × Return in Each Scenario) |
| Expected Return Example: 60% chance of 10%, 40% chance of 2% — what’s the expected return? | 6.8% |
| Why is expected return useful? | It helps investors decide if an investment is worth pursuing. |
| What is Real Return? | The return adjusted for inflation, reflecting true purchasing power. |
| What is the formula for Real Return? | Real Return = Nominal Return – Inflation Rate |
| Real Return Example: 1980 → 15% nominal, 5% inflation — what’s the real return? | 10% |
| Real Return Example: 2010 → 12% nominal, 5% inflation — what’s the real return? | 7% |
| Who gained more purchasing power—1980 or 2010? | 1980, because the real return was higher (10% vs. 7%). |
| Which return measure reflects total past performance of an asset? | Holding Period Return (HPR) |
| Which return measure helps forecast future performance? | Expected Return |
| Which return measure adjusts for inflation? | Real Return |
| What is risk in finance? | The possibility that actual returns will differ from expected returns. |
| What does risk reflect in investing? | Uncertainty in investment outcomes. |
| How is investment risk measured? | Using standard deviation (SD) of returns. |
| Higher standard deviation means what? | More risk. |
| Example: Which stock is riskier — AMD (SD = 18.41%) or COKE (SD = 8.07%)? | AMD — higher standard deviation. |
| What are the two main types of risk? | Systematic (market) risk and unsystematic (firm-specific) risk. |
| What is systematic risk? | Risk affecting the entire market or economy — cannot be diversified away. |
| Examples of systematic risk? | Interest rate changes, recessions, natural disasters, global crises. |
| What is unsystematic risk? | Risk specific to a company or sector — can be reduced through diversification. |
| Examples of unsystematic risk? | Executive turnover, product recalls, labor strikes, surprise earnings. |
| What is interest rate risk? | Risk of bond values changing due to fluctuations in interest rates. |
| How do rising interest rates affect bond prices? | Bond prices decrease. |
| Is interest rate risk diversifiable? | No, it’s systematic. |
| Which bonds are more sensitive to interest rate risk? | Long-term bonds and those with low coupon rates. |
| What is default risk? | The risk that a borrower will fail to repay a loan. |
| How is default risk measured? | Through credit ratings (AAA = safest, D = default). |
| What are investment-grade and junk bond ratings? | BBB and above = investment-grade; BB and below = junk/high-yield. |
| Is default risk diversifiable? | No, it’s systematic. |
| What is price risk? | Risk that an asset’s price deviates from expectations due to firm-specific events. |
| Is price risk diversifiable? | Yes. |
| Causes of price risk? | Operating risk, financial risk, industry risk. |
| What is financial risk? | Risk from a company’s use of debt (capital structure). |
| What can financial risk lead to? | Difficulty in payments, potential default, and shareholder losses. |
| Is financial risk diversifiable? | Partially. |
| What type of risk is diversifiable? | Unsystematic risks like price risk and partially financial risk. |
| What type of risk is non-diversifiable? | Systematic risks like interest rate and default risk. |
| Why is understanding risk important? | To assess return potential and protect investments through diversification. |
| What is financial risk management? | The process of making strategic decisions to reduce, transfer, retain, or avoid potential losses in personal or business finance. |
| What is the goal of risk reduction (mitigation)? | To minimize the potential impact of a risk through proactive measures. |
| Examples of risk reduction? | Hotels posting warning signs to shift liability or homeowners buying flood insurance. |
| Key point of risk reduction? | Reduce the chance or impact of loss through preventive actions. |
| What is diversification in risk management? | Spreading investments across different assets to reduce firm-specific risk. |
| How does diversification help reduce risk? | By spreading investments to lower firm-specific risk, but it doesn't reduce market (systematic) risk. |
| Saying to remember about diversification? | "Don’t put all your eggs in one basket." |
| What is risk separation? | Distributing key assets across multiple locations to protect against localized disasters. |
| Example of risk separation? | Internet companies placing servers in different cities/countries to avoid total service loss in case of a disaster. |
| Key point of risk separation? | Geographic separation protects operations from total loss in one location. |
| What is risk transfer? | Shifting risk to another party, often through insurance. |
| Example of risk transfer? | A business paying premiums for insurance against property damage or cyberattacks. |
| Key point of risk transfer? | Transfer the financial burden of potential loss to a third party in exchange for a premium. |
| What is risk retention? | Consciously accepting and managing a risk internally instead of transferring it. |
| When is risk retention used? | When the risk is low, insurance is expensive, or the benefits outweigh the costs. |
| Examples of risk retention? | Pharmaceutical firms investing in drugs despite high R&D failure risks or venture capital firms accepting startup failure risks. |
| Key point of risk retention? | It's a strategic choice when the cost of insuring outweighs the potential loss. |
| What is risk avoidance? | Completely avoiding activities that carry unacceptable risks. |
| Example of risk avoidance? | An oil company choosing not to develop a profitable reserve in a war-torn country due to high security risks. |
| Key point of risk avoidance? | Eliminate exposure by choosing not to participate in risky activities. |
| What is the final insight about diversification? | Diversification can reduce individual asset risk, but market risk always remains. |
| Which type of risk can be reduced by adding a variety of different assets into a portfolio? | Firm-specific risk |
| How is risk separation different from diversification? | Risk separation involves dispersing assets geographically instead of concentrating them in one location. |
| Which situation is a real-life example of risk transfer? | Buying home insurance—risk is transferred from the policyholder to the insurer |
| Why would a company or individual want to retain risk? | Both companies and individuals retain risk when they believe that the cost of pursuing an activity is less than the alternative. |
| What is the relationship between risk and return in investing? | Higher risk is associated with higher potential return to compensate for uncertainty. |
| What is systematic risk? | The market-wide risk that cannot be eliminated through diversification. |
| Why does systematic risk matter in the risk-return relationship? | Because it affects all firms and determines the expected return based on the level of market exposure. |
| Give an example of a company with high systematic risk. | Apple—its performance is strongly tied to market conditions and fluctuates more with economic changes. |
| Give an example of a company with low systematic risk. | Utility companies—they offer essential services and are less affected by market swings. |
| What type of risk cannot be diversified away? | Systematic risk. |
| What is the risk-return trend across countries? | Countries with higher economic or political risk offer higher bond returns (e.g., Pakistan vs. Australia). |
| What is the relationship between bond credit ratings and returns? | Lower-rated (riskier) bonds offer higher returns than higher-rated (safer) ones. |
| How do returns vary among financial products like checking accounts, T-bills, and the S&P 500? | Safer, more liquid assets (checking accounts, T-bills) offer lower returns; riskier assets (stocks) offer higher returns. |
| What is time diversification? | The principle that holding risky assets over longer periods reduces the probability of loss. |
| How did $1 invested in different assets grow from 1962 to 2018? | S&P 500 → $213.03 10-Year T-bill → $28.93 AAA Bonds → $49.85 CPI (inflation) → $8.28 |
| What does probability of loss show about long-term investing in stocks? | The probability of loss decreases significantly with longer holding periods (e.g., 29% for 1 year vs. 0% for 20 years). |
| What is the key principle for aligning investments with goals? | Match your investment horizon and risk tolerance to your financial goals. |
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