103-5 Types Of Investment Risk & Quantitative Investment Concepts

Question 1

Investment Risk

Answer 1

The uncertainty that an investment’s actual, or realized, return will be different from its expected return
2 most important strategies that assist investors in managing investment risk are diversification and asset allocation

Question 2

Diversification

Answer 2

Structuring an individual’s investment portfolio to maximize risk/return
An investor should attempt to realize the greatest amount of return per unit of risk

Question 3

Portfolio Diversification

Answer 3

Reduces unsystematic risk and enhances returns

Question 4

Unsystematic risk

Answer 4

Aka diversifiable risk
Risk that affects only a particular company, country, or sector and its securities
Examples: business risk, financial risk, liquidity risk, marketability risk, default risk, political risk, tax risk, investment manager risk

Question 5

Systematic Risk

Answer 5

Aka nondiversifiable risk
Reflects the uncertainty of returns associated w/ an investment in any type of asset
Generally considered inescapable
A portfolio manager hopes to minimize systematic risk

Question 6

Purchasing Power Risk

Answer 6

The potential loss of the purchasing power of an investment due to inflation

Question 7

Reinvestment Rate Risk

Answer 7

The risk that proceeds available for reinvestment must be reinvested at a lower rate of return than that of the investment vehicle that generated the proceeds
To eliminate: invest in zero-coupon bonds

Question 8

Interest Rate Risk

Answer 8

The risk that the market price of an investment will decline as the result of changes in market IR

Question 9

Market Risk

Answer 9

Another word for systematic risk
Market risk is the risk of the overall securities marketplace and is sometimes simply referred to as volatility
The more volatile the security’s return (as measured by beta), the greater its risk in comparison to a market index, such as the Standard & Poor’s 500 Index

Question 10

Exchange Rate Risk

Answer 10

The risk that a change in the relationship between the value of the dollar and the value of the foreign currency during the period of investment will negatively affect the investor’s return

Question 11

Beta

Answer 11

A relative measure of systematic risk or volatility
Overall market has a beta of +1.0
Beta > 1 = aggressive asset
Beta < 1 = defensive asset

Question 12

Weighted Beta

Answer 12

Beta of a portfolio of securities

Meaning that the portfolio beta is calculated by weighting the individual asset betas and adding the results

Question 13

Stochastic Modeling

Answer 13

A method of financial analysis that attempts to forecast how investment returns on different asset classes vary over time by using thousands of simulations to produce probability distributions for various outcomes

Question 14

Monte Carlo Simulation (MCS)

Answer 14

Popular form of stochastic modeling

Question 15

Sensitivity Analysis

Answer 15

Used to evaluate the risk associated w/ a given investment and assesses the impact of different variables on an investment’s return

Question 16

Weighted Average Return

Answer 16

Represents the return for a set of securities, such as a portfolio, where each return is weighted by the proportion of the security to the entire group or portfolio

Question 17

Standard Deviation

Answer 17

Aka variance
An absolute measure of the variability of the actual investment returns around the average or mean of those returns (otherwise known as the expected return of the investment)
A return will occur 68% of the time within one SD of the mean

Question 18

Normal Probability Distribution

Answer 18

Perfectly symmetrical, characterized by a single peak in the center, which is the location of the arithmetic mean of the series of observations

Question 19

Mean

Answer 19

An absolute value and is the best indicator of central tendency of a distribution

Question 20

Median

Answer 20

The central value of observations arranged in order of lowest to highest

Question 21

Mode

Answer 21

The observation value w/ the greatest frequency

Question 22

Z-Statistic (z-score)

Answer 22

Measures the # of standard deviations a data value is from the mean (either above or below)
This score is obtained by subtracting the mean from a given data value and dividing this result by the standard deviation
If the data value is higher than the mean, then the z-score will be positive
If the data value is smaller than the mean, then the z-score will be negative

Question 23

Lognormal probability distribution

Answer 23

One in which the series of observations is skewed to the left of the arithmetic mean (i.e., the mean is to the right of the peak of the series)

Question 24

Skewness

Answer 24

Measures how far the actual outcomes of a probability distribution deviate from the arithmetic mean or the asymmetry of the distribution

Question 25

Positively skewed distributions

Answer 25

The median is below the mean (long tail is on positive side of the peak)
An investment w/ positive skewness subjects the investor to a greater # of returns below the mean

Question 26

Negatively skewed distributions

Answer 26

The median is above the mean (long tail is on negative side of the peak)
An investment exhibiting a high positive skewness may have a larger than avg number of positive price movements than an investment w/ low positive skewness

Question 27

Kurtosis

Answer 27

Measures the degree of peak in a distribution of returns
Measures the degree to which exceptional values (those much higher or lower than average) occur more frequently (high kurtosis) or less frequently (low kurtosis)

Question 28

Playkurtic Distribution

Answer 28

Less peaked distribution indicates that more returns w/ large deviations from the mean have occurred, or are expected to occur, than a normal distribution

Question 29

Leptokurtic Distribution

Answer 29

More peaked distribution indicates that more returns are clustered around than mean than w/ a normal distribution
Investors who want to minimize volatility in their portfolios would prefer a leptokurtic distribution

Question 30

Semivariance

Answer 30

Used to measure only those returns that are below the mean, w/ no consideration given to those above the mean
Semivariance is described as the average square deviation below the mean
The lower the semivariance of a security, the less likely the security will incur a substantial loss in value

Question 31

Covariance

Answer 31

Measures the extent to which 2 variables (the returns on investment assets) move together, either positively (together) or negatively (opposite)

Question 32

Correlation Coefficient

Answer 32

Provides similar information on the movement of two assets’ returns
This measures the strength of the straight-line or linear relationship between 2 variables
The overall range of values lies between -1.0 and +1.0
Perfectly correlated assets = +1.0
Perfectly negatively correlated assets = -1.0
No linear relationship = 0.0

Question 33

Standard deviation of a 2 asset portfolio

Answer 33

Pg 96-97

Question 34

Coefficient of Determination

Answer 34

R-Squared
The square of the correlation coefficient, describes the % of variability in one variable (e.g. a stock) that is explained by the changes in a 2nd varaible (e.g. the overall market) or the strength of the relationship between the 2 variables
Example: if the coefficient of determination between ABC stock and the market is 70%, then 70% of ABC’s movement in price may be explained by changes affecting the overall market
The higher the coefficient of determination of the stock or portfolio, the more the overall market is an appropriate benchmark for the measurement of investment risk