Definition of Risk-adjusted profitability

Risk-adjusted profitability

A probability used to determine a "sure" expected value (sometimes called a
certainty equivalent) that would be equivalent to the actual risky expected value.

Adjusted present value (APV)

The net present value analysis of an asset if financed solely by equity
(present value of un-levered cash flows), plus the present value of any financing decisions (levered cash
flows). In other words, the various tax shields provided by the deductibility of interest and the benefits of
other investment tax credits are calculated separately. This analysis is often used for highly leveraged
transactions such as a leverage buy-out.

Bankruptcy risk

The risk that a firm will be unable to meet its debt obligations. Also referred to as default or insolvency risk.

Basis risk

The uncertainty about the basis at the time a hedge may be lifted. Hedging substitutes basis risk for
price risk.

Business risk

The risk that the cash flow of an issuer will be impaired because of adverse economic
conditions, making it difficult for the issuer to meet its operating expenses.

Call risk

The combination of cash flow uncertainty and reinvestment risk introduced by a call provision.

Commercial risk

The risk that a foreign debtor will be unable to pay its debts because of business events,
such as bankruptcy.

Company-specific risk

Related: Unsystematic risk

Completion risk

The risk that a project will not be brought into operation successfully.

Counterparty risk

The risk that the other party to an agreement will default. In an options contract, the risk
to the option buyer that the option writer will not buy or sell the underlying as agreed.
Country economic risk Developments in a national economy that can affect the outcome of an international
financial transaction.

Country financial risk

The ability of the national economy to generate enough foreign exchange to meet
payments of interest and principal on its foreign debt.

Country risk General

Level of political and economic uncertainty in a country affecting the value of loans or
investments in that country.

Credit risk

The risk that an issuer of debt securities or a borrower may default on his obligations, or that the
payment may not be made on a negotiable instrument. Related: Default risk

Cross-border risk

Refers to the volatility of returns on international investments caused by events associated
with a particular country as opposed to events associated solely with a particular economic or financial agent.

Currency risk

Related: Exchange rate risk

Currency risk sharing

An agreement by the parties to a transaction to share the currency risk associated with
the transaction. The arrangement involves a customized hedge contract embedded in the underlying
transaction.

Default risk

Also referred to as credit risk (as gauged by commercial rating companies), the risk that an
issuer of a bond may be unable to make timely principal and interest payments.

Diversifiable risk

Related: unsystematic risk.

Economic risk

In project financing, the risk that the project's output will not be salable at a price that will
cover the project's operating and maintenance costs and its debt service requirements.

Equilibrium market price of risk

The slope of the capital market line (CML). Since the CML represents the
return offered to compensate for a perceived level of risk, each point on the line is a balanced market
condition, or equilibrium. The slope of the line determines the additional return needed to compensate for a
unit change in risk.

Event risk

The risk that the ability of an issuer to make interest and principal payments will change because
of rare, discontinuous, and very large, unanticipated changes in the market environment such as (1) a natural
or industrial accident or some regulatory change or (2) a takeover or corporate restructuring.

Exchange rate risk

Also called currency risk, the risk of an investment's value changing because of currency
exchange rates.

Exchange risk

The variability of a firm's value that results from unexpected exchange rate changes or the
extent to which the present value of a firm is expected to change as a result of a given currency's appreciation
or depreciation.

Fallout risk

A type of mortgage pipeline risk that is generally created when the terms of the loan to be
originated are set at the same time as the sale terms are set. The risk is that either of the two parties, borrower
or investor, fails to close and the loan "falls out" of the pipeline.

Financial risk

The risk that the cash flow of an issuer will not be adequate to meet its financial obligations.
Also referred to as the additional risk that a firm's stockholder bears when the firm utilizes debt and equity.

Firm-specific risk

See:diversifiable risk or unsystematic risk.

Flat price risk

Taking a position either long or short that does not involve spreading.

Force majeure risk

The risk that there will be an interruption of operations for a prolonged period after a
project finance project has been completed due to fire, flood, storm, or some other factor beyond the control
of the project's sponsors.

Foreign exchange risk

The risk that a long or short position in a foreign currency might have to be closed out
at a loss due to an adverse movement in the currency rates.

Funding risk

Related: interest rate risk

Geographic risk

risk that arises when an issuer has policies concentrated within certain geographic areas,
such as the risk of damage from a hurricane or an earthquake.

Herstatt risk

The risk of loss in foreign exchange trading that one party will deliver foreign exchange but the counterparty financial institution will fail to deliver its end of the contract. It is also referred to as settlement risk.

Idiosyncratic Risk

Unsystematic risk or risk that is uncorrelated to the overall market risk. In other words,
the risk that is firm specific and can be diversified through holding a portfolio of stocks.

Inflation risk

Also called purchasing-power risk, the risk that changes in the real return the investor will
realize after adjusting for inflation will be negative.

Insolvency risk

The risk that a firm will be unable to satisfy its debts. Also known as bankruptcy risk.

Interest rate risk

The risk that a security's value changes due to a change in interest rates. For example, a
bond's price drops as interest rates rise. For a depository institution, also called funding risk, the risk that
spread income will suffer because of a change in interest rates.

Liquidity risk

The risk that arises from the difficulty of selling an asset. It can be thought of as the difference
between the "true value" of the asset and the likely price, less commissions.

Market price of risk

A measure of the extra return, or risk premium, that investors demand to bear risk. The
reward-to-risk ratio of the market portfolio.

Market risk

risk that cannot be diversified away. Related: systematic risk

Mortgage-pipeline risk

The risk associated with taking applications from prospective mortgage borrowers
who may opt to decline to accept a quoted mortgage rate within a certain grace period.

Net adjusted present value

The adjusted present value minus the initial cost of an investment.

Nondiversifiable risk

risk that cannot be eliminated by diversification.

Nonsystematic risk

Nonmarket or firm-specific risk factors that can be eliminated by diversification. Also
called unique risk or diversifiable risk. Systematic risk refers to risk factors common to the entire economy.

Operating risk

The inherent or fundamental risk of a firm, without regard to financial risk. The risk that is
created by operating leverage. Also called business risk.

Option-adjusted spread (OAS)

1) The spread over an issuer's spot rate curve, developed as a measure of
the yield spread that can be used to convert dollar differences between theoretical value and market price.
2) The cost of the implied call embedded in a MBS, defined as additional basis-yield spread. When added to the
base yield spread of an MBS without an operative call produces the option-adjusted spread.

Overnight delivery risk

A risk brought about because differences in time zones between settlement centers
require that payment or delivery on one side of a transaction be made without knowing until the next day
whether the funds have been received in an account on the other side. Particularly apparent where delivery
takes place in Europe for payment in dollars in New York.

Political risk

Possibility of the expropriation of assets, changes in tax policy, restrictions on the exchange of
foreign currency, or other changes in the business climate of a country.

Price risk

The risk that the value of a security (or a portfolio) will decline in the future. Or, a type of
mortgage-pipeline risk created in the production segment when loan terms are set for the borrower in advance
of terms being set for secondary market sale. If the general level of rates rises during the production cycle, the
lender may have to sell his originated loans at a discount.

Product risk

A type of mortgage-pipeline risk that occurs when a lender has an unusual loan in production or
inventory but does not have a sale commitment at a prearranged price.

Profitability index

The present value of the future cash flows divided by the initial investment. Also called
the benefit-cost ratio.

Profitability ratios

Ratios that focus on the profitability of the firm. Profit margins measure performance
with relation to sales. Rate of return ratios measure performance relative to some measure of size of the
investment.

Purchasing-power risk

Related: inflation risk

Rate risk

In banking, the risk that profits may decline or losses occur because a rise in interest rates forces up
the cost of funding fixed-rate loans or other fixed-rate assets.

Regulatory pricing risk

risk that arises when regulators restrict the premium rates that insurance companies
can charge.

Reinvestment risk

The risk that proceeds received in the future will have to be reinvested at a lower potential
interest rate.

Residual risk

Related: unsystematic risk

Reverse price risk

A type of mortgage-pipeline risk that occurs when a lender commits to sell loans to an
investor at rates prevailing at application but sets the note rates when the borrowers close. The lender is thus
exposed to the risk of falling rates.

Risk

Typically defined as the standard deviation of the return on total investment. Degree of uncertainty of
return on an asset.

Risk arbitrage

Speculation on perceived mispriced securities, usually in connection with merger and
acquisition deals. Mike Donatelli, John Demasi, Frank Cohane, and Scott Lewis are all hardcore arbs. They
had a huge BT/MCI position in the summer of 1997, and came out smelling like roses.

Risk averse

A risk-averse investor is one who, when faced with two investments with the same expected
return but two different risks, prefers the one with the lower risk.

Risk classes

Groups of projects that have approximately the same amount of risk.

Risk controlled arbitrage

A self-funding, self-hedged series of transactions that generally utilize mortgage
securities as the primary assets.

Risk indexes

Categories of risk used to calculate fundamental beta, including (1) market variability, (2)
earnings variability, (3) low valuation, (4) immaturity and smallness, (5) growth orientation, and (6) financial risk.

Risk lover

A person willing to accept lower expected returns on prospects with higher amounts of risk.

Risk management

The process of identifying and evaluating risks and selecting and managing techniques to
adapt to risk exposures.

Risk neutral

Insensitive to risk.

Risk prone

Willing to pay money to transfer risk from others.

Risk premium

The reward for holding the risky market portfolio rather than the risk-free asset. The spread
between Treasury and non-Treasury bonds of comparable maturity.

Risk premium approach

The most common approach for tactical asset allocation to determine the relative
valuation of asset classes based on expected returns.

Riskless rate

The rate earned on a riskless investment, typically the rate earned on the 90-day U.S. Treasury Bill.

Riskless rate of return

The rate earned on a riskless asset.

Riskless arbitrage

The simultaneous purchase and sale of the same asset to yield a profit.

Riskless or risk-free asset

An asset whose future return is known today with certainty. The risk free asset is
commonly defined as short-term obligations of the U.S. government.

Risky asset

An asset whose future return is uncertain.

Risk-adjusted

return Return earned on an asset normalized for the amount of risk associated with that asset.

Risk-free asset

An asset whose future return is known today with certainty.

Risk-free rate

The rate earned on a riskless asset.

Shortfall risk

The risk of falling short of any investment target.

Sovereign risk

The risk that a central bank will impose foreign exchange regulations that will reduce or
negate the value of FX contracts. Also refers to the risk of government default on a loan made to it or
guaranteed by it.

Specific risk

See:unique risk.

Systematic risk

Also called undiversifiable risk or market risk, the minimum level of risk that can be
obtained for a portfolio by means of diversification across a large number of randomly chosen assets. Related:
unsystematic risk.

Systematic risk principle

Only the systematic portion of risk matters in large, well-diversified portfolios.
The, expected returns must be related only to systematic risks.

Undiversifiable risk

Related: Systematic risk

Unique risk

Also called unsystematic risk or idiosyncratic risk. Specific company risk that can be eliminated
through diversification. See: diversifiable risk and unsystematic risk.

Unsystematic risk

Also called the diversifiable risk or residual risk. The risk that is unique to a company
such as a strike, the outcome of unfavorable litigation, or a natural catastrophe that can be eliminated through diversification.
Related: Systematic risk

Value-at-Risk model (VAR)

Procedure for estimating the probability of portfolio losses exceeding some
specified proportion based on a statistical analysis of historical market price trends, correlations, and volatilities.

Volatility risk

The risk in the value of options portfolios due to the unpredictable changes in the volatility of
the underlying asset.

Profitability index

See cash value added.

Asset-specific Risk

The amount of total risk that can be eliminated by diversification by
creating a portfolio. Also known as company-specific risk or
unsystematic risk.

Companyspecific Risk

See asset-specific risk

Market Risk

The amount of total risk that cannot be eliminated by portfolio
diversification. The risk inherent in the general economy as a
whole. Also known as systemic risk.

Profitability Index

A method for determining the profitability of an investment. It is
calculated by dividing the present value of the future net cash flows
by the initial cash investment.

Risk Premium

The additional rate of return required on a risky project
(investment) when compared to a risk-free project (investment)

Risk-free Rate

The rate of return on an investment with known future benefits; a
riskless rate of return, often estimated using the return earned on
short-term U.S. Treasury securities

Systematic Risk

The amount of total risk that cannot be eliminated by portfolio
diversification. The risk inherent in the general economy as a
whole. Also known as market risk.

Unsystematic Risk

The amount of total risk that can be eliminated by diversification by
creating a portfolio. Also known as asset-specific risk or
company-specific risk.

judgmental method (of risk adjustment)

an informal method of adjusting for risk that allows the decision maker
to use logic and reason to decide whether a project provides
an acceptable rate of return

profitability index (Pl)

a ratio that compares the present value of net cash flows to the present value of the net investment

risk

uncertainty; it reflects the possibility of differences between
the expected and actual future returns from an investment

risk-adjusted discount rate method

a formal method of adjusting for risk in which the decision maker increases the rate used for discounting the future cash flows to compensate for increased risk

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