3. Investment Planning. 5. Investment Risks Flashcards
Module Introduction
Imagine being an investor at the time of the Crash of 1929 and realizing that you lost all of your savings that was invested in the stock market. Picture the images of distraught businessmen leaping out of buildings and the poverty that followed in the years of the Great Depression. These images burn in the minds of those who lived through it and will forever be associated with the risk of investing. The risk of the market alone wasn’t what caused people to jump to their deaths, rather, it was the enhanced risk caused by leverage. People were investing beyond their means by buying on margin, and as a result lost more than they had invested; in many cases, they lost more than all of their net worth!
In truth, investment risk is a necessary evil for those looking to achieve returns higher than the 90 day T-bill rate, which is commonly accepted in investment planning as a risk-less or risk free asset. Risk is a measurable possibility that an investment will lose or gain value. This module identifies some forces that make investment prices fluctuate, and measures of probability. Probability analysis helps give investors an idea of what risks are associated with their investments.
The Investment Risks module, which should take approximately three and a half hours to complete, will explain the various sources of investment risks and the application of probability analysis to calculate risk.
Upon completion of this module you should be able to:
* Identify and explain the sources of risks, and
* Calculate risk using probability analysis.
* The follow graphic illustrates the risk and reward relationships of different asset classes.
Module Overview
Risk goes hand in hand with potential return.The more risk you are willing to take, the greater the potential return. However, it also means the greater the possibility that you will lose money. Hence, probability analysis helps you to limit downside risk without offsetting all of the potential return.
To ensure that you have a solid understanding of investment risks, the following lessons will be covered in this module:
* Sources of Investment Risks
* Probability Analysis
Section 1 – Sources of Investment Risks
The compensation that investors demand for taking on added risk is called risk premium. The premium amount differs for every investment because every investment has a different level of risk. This lesson will discuss the sources of risk to give you an understanding of what causes fluctuations in the prices and values of different investments.
Some risks are systematic (or nondiversifiable risks / market risks). They are forces that affect all investments. Other risks are unsystematic (or diversifiable / company or industry specific risks). These risks are specific to the security or the security’s industry. Remember that the sources of risks are not mutually exclusive - that is, there is a good deal of overlap between them.
To ensure that you have an understanding of the sources of investment risks, the following topics will be covered in this lesson:
* Interest Rate Risk
* Reinvestment Risk
* Inflation (Purchasing Power) Risk
* Business Risk
* Tax Risk
* Investment Manager Risk
* Financial Risk
* Liquidity Risk
* Market Risk
* Political and Regulatory Risk
* Exchange Rate Risk
* Sovereign Risk
* Call (Prepayment) Risk
After completing this lesson, you should be able to:
* Define interest rate risk,
* Discuss reinvestment risk,
* Explain inflation (purchasing power) risk,
* Elaborate on business risks,
* Define tax risk,
* Discuss investment manager risk,
* Discuss financial risk,
* Describe liquidity risk,
* Explain market risk,
* Detail political and regulatory risks,
* Define exchange rate risk,
* Discuss sovereign risk, and
* Explain call (prepayment) risk.
Describe Business Risk
Most stocks and corporate bonds are influenced by how well or poorly the company that issued them is performing. Business risk deals with fluctuations in investment value that are caused by good or bad management decisions, or how well or poorly the firm’s products are doing in the marketplace. Businesses can go bankrupt, and management can make poor decisions. A CEO’s decision to leave a company, or a company’s decision to lay off part of their staff, may cause the share price of the company’s stock to rise or fall depending on the impact of the decision on the company’s performance. Business risk is specific to the stock or bond that the business issues. Business risk is a type of unsystematic, or diversifiable risk.
PRACTITIONER ADVICE: Business risk is the source for potential downside risk as well as upside return. The reason why some people buy specific stocks is because they believe something specific about that business will yield a profit for them. The downside of business risk can be limited through diversification. If an investor bought a portfolio of securities rather than holding only one company’s securities, the investor will limit the effects of the downside risk of one company to his or her entire investment.
Which of the following are examples of business risk? Click all that apply.
Change the manufacturer process
* Reinvestment
* Inflation
* CEO charged with unethical business practices
* Interest rates
* Leverage buy out
Change the manufacturer process
CEO charged with unethical business practices
Leverage buy out
* Business specific risks are uniquely associated with the company or entity issuing the security. Change is processes may increase short-term expenses but improve a company’s efficiency in production in the lon-term. A company being bought out can be beneficial (company is broken up and sold in pieces). Charges for any illegal activities or business practices can be detrimental for the company’s stock.
Section 1 – Sources of Investment Risks Summary
There are a number of different sources of risk associated with investments. These range from systematic (undiversifiable) risks like interest rate and inflation risks, to more unsystematic (diversifiable) risks like exchange rate and call risks. In this lesson, we have covered the following:
* Interest Rate Risk refers to fluctuations in security prices due to changes in the market interest rate. Since the interest rates of all securities fluctuate, it is impossible to eliminate interest rate risk.
* Reinvestment Risk is the investor’s inability to know the interest rate at which the proceeds from a maturing investment can be reinvested for the remainder of its holding period.
* Inflation Risk refers to the possibility of changes in the level of inflation resulting in interest rate changes. An unexpected rise in inflation may cause a seemingly solid financial plan to fall short in achieving its goals.
* Business Risk deals with fluctuations in investment value caused by management decisions, or the performance of the firm’s products.
* Tax Risk is defined as the investor being burdened with an unexpected tax liability. This risk is considered to be a diversifiable, unsystematic risk.
- Investment Manager Risk occurs when an investor has delegated investment management responsibility to an investment manager and that investment manager does not perform as expected.
- Financial Risk is associated with the use of debt by firms. The manner in which a firm raises money affects its level of risk.
- Liquidity Risk deals with the inability of the investor to liquidate a security quickly and at a fair market price.
- Market Risk is associated with overall market movements, including bull and bear markets.
- Political and Regulatory Risk is a result of unexpected changes in the tax or legal environments, as imposed by the government.
- Exchange Rate Risk refers to the variations in earnings caused by changes in exchange rates. This is a common risk for the international investor.
- Sovereign Risk refers to the risk incurred by investors in a foreign country. This would include the risk of government collapse, inadequate legal systems, law and order problems, and any other problems that affect the economy of that country.
- Call (Prepayment) Risk applies only to callable bonds and mortgage pass-through investments. The risk is that a bond may be called away from bondholders before maturity and the investor will need to reinvest in a lower interest rate environment.
Market risk results only from fluctuations in security prices due to changes in the market interest rate.
* False
* True
False
* Market risk is associated with overall market movements, not just changes in interest rate.
* The interest rate risk is, in fact, associated specifically with changes in the market interest rate.
Why would a company call its outstanding bond issues?
* Interest rates are rising
* Inflation rates are rising
* Interest rates are decreasing
* Exchanging rates are decreasing
Interest rates are decreasing
* When interest rates decrease, it gives a company incentive to exercise its right to call its outstanding bonds and issue new bonds in the current interest environment. This helps to lower the interest expense for the company and allow it to use the money on other things. Therefore when interest rates rise, companies would not call its debt because its existing interest expense is lower than current rates. Inflation and exchange rates have no direct relationship with the decision to call a bond issue.
Match the description with the risk.
Business Risk
Liquidity Risk
Financial Risk
Sovereign Risk
* Subject to foreign country seizing investment
* Associated with the use of debt by firms
* Inability to find a buyer at a fair market price
* Can be caused by management decisions
- Business Risk - Can be caused by management decisions
- Liquidity Risk - Inability to find a buyer at a fair market price
- Financial Risk - Associated with the use of debt by firms
- Sovereign Risk - Subject to foreign country seizing investment
Section 2 - Probability Analysis
Quantitative methods underlie most of the concepts of risk assessment and all of the investment statistics we use in investment planning. By far, one of the most commonly used applications under the term probability analysis is that of a normal distribution or normal curve. This symmetrical bell-shaped probability curve is used to interpret standard deviation, semi-variances and the important concept of downside risk.
To ensure that you have a solid understanding of probability analysis, the following topics will be covered in this lesson:
* Normal Distribution
* Skewness
* Lognormal Distribution
* Expected Rate of Return
* Risk Estimates
* Asset’s Total Risk
Upon completion of this lesson, you should be able to:
* Discuss a normal distribution,
* Describe skewness,
* Define lognormal distributions,
* Define the expected rate of return,
* Discuss how risk is estimated, and
* Assess an asset’s total risk.
Describe characteristics of Normal Distribution
The symmetrical, bell-shaped distribution known as a normal distribution plays the center role in the mean-variance model of portfolio selection. The normal probability distribution is also used extensively in financial risk management. The normal distribution has the following characteristics:
* Its shape is perfectly symmetrical.
* Its mean and median are equal.
* It is completely described by two parameters - its mean and variance.
* The probability of a return greater than the mean is 50%.
* The probability of a return less than its mean is 50%.
* There is approximately a 68% probability that the actual return will lie within + / - one standard deviation from the mean.
* There is approximately a 95% probability that the actual return will lie within + / - two standard deviations from the mean.
* There is approximately a 99% probability that the actual return will lie within + / - three standard deviations from the mean.
Exam Tip: Write it out! When you encounter a problem in which you are provided with a mean return and standard deviation, then asked to solve for the probability of a certain return, draw a bell curve, split it down the middle, write the mean return at the midpoint, and work outward to identify the standard deviations. From there, apply the probabilities between the appropriate standard deviations to solve.
What is important to realize about the lognormal distribution?
PRACTITIONER ADVICE: You will not be responsible for the creation or formulation of a lognormal distribution.
* However, it is important to realize that the lognormal distribution has been found to be very accurate in the distribution of prices for many financial assets.
* In fact, the primary principal of the Black-Scholes-Merton Option Pricing Model is that the asset underlying the option is lognormally distributed.
Describe Coefficient of Determination
- The correlation coefficient squared is called the coefficient of determination, “R2”, or “R-squared.” R-squared measures the portion of the asset’s performance that can be attributed to the returns of the overall market. Since the correlation of coefficient’’s value is between -1 and 1, R-squared’s values can only be between 0 and 1 (the square of anything less than zero will equal a positive number).
- If R-squared = 1, then the asset’s return is perfectly correlated with the return of the market.
- If R-squared = 0, then the asset’s return has nothing to do with the market’s return.
- The closer to one that an asset’s R-squared value is, the more reliable its beta. if an asset’s R-squared is below .7, then Beta and everything that uses Beta (like the Treynor ratio and Jensen’s Alpha) would be a meaningless statistic.
François, a wholesaler for Les Bleus Funds, visits your office and presents two investment alternatives.
Lamarck Fund: R2 = 0.24, ß = 1.60
Montaigne Fund: R2 = 0.89, ß = 1.04
Which of these investments is more likely to provide returns that outperform the market during an expansion?
* Lamarck Fund
* Montaigne Fund
Montaigne Fund
* The Montaigne Fund is more likely to outperform the market during an expansion. With an R2 of 0.24, Lamarck Fund’s Beta is not reliable. As a result, the Montaigne Fund is more likely to outperform the market due to its reliable R2 of 0.89, and a Beta of 1.04 that suggests that it will outperform the market.
Section 2 - Probability Analysis Summary
Investment analysts represent assets as probability distributions of returns that summarize everything known about the asset. Asset risk and average (expected) return statistics are computed from the data in their probability distributions of returns. These statistics provide market-determined measures that offer a scientific and unemotional approach to security analysis. In this lesson, we have covered the following:
* Normal Distributions are symmetrical, bell-shaped distributions used in financial risk management to determine the likelihood of actual returns lying in a particular range, as well as below some predetermined amount in applications such as semi-variance and downside risk.
* Skewness refers to the extent to which a distribution is not symmetrical. Real-world distributions are usually skewed, either positively (to the right) or negatively (to the left).
* Lognormal Distributions are defined by the mean and the variance of the underlying normal distribution itself.
- Risk Estimates are calculated by measuring standard deviation and the variance of an asset’s rates of return. Kurtosis is the statistical measure used to determine the degree that a return is more peaked (leptokurtic with fat tails) or less peaked (platykurtic with thin tails) versus a normal distribution.
- Correlation Coefficient measures how closely the data points fit the characteristic line.
- Beta is the slope coefficient of the characteristic line. It illustrates how much more or less aggressive an asset is compared to its market. Beta only measures systematic risk, and therefore, if an asset’s R-squared is low, then Beta and everything that uses Beta (like the Treynor ratio and Jensen’s Alpha) would be a meaningless statistic.
- Coefficient of Determination (R-squared) is the mathematical square of the correlation coefficient. It predicts the accuracy of beta and represents the portion of the asset’s return that is nondiversifiable (systematic). It is important to know that one minus R-squared shows the amount of an assets return that is due to unsystematic (diversifiable) risk.
- Asset’s Total Risk is measured by its variance of returns. It is split into two components, diversifiable risk and nondiversifiable risk. The only measure of an asset’s total risk is standard deviation.
Module Summary
You need to accept some risk to meet your long-term financial goals. Therefore, you must balance the amount of risk you are willing to take with the amount of return you need. Whether you are advising a client or analyzing your own portfolio, it is helpful to understand what causes the value of the portfolio to fluctuate and to identify how much of that fluctuation is diversifiable and how much is undiversifiable.
The following are the key concepts to remember:
- Sources of Investment Risks: Various sources of risk are associated with investments, including interest rate risk, reinvestment risk, call risk, and business risk. These sources are not mutually exclusive — there is a good deal of overlap between them. They cause the value of investments to fluctuate over time.
- Probability Analysis: A list of possible rates of return on investments and their probabilities is called a probability distribution of returns. Investment analysts represent assets as probability distributions of returns.
YOUTUBE - FP Formulas: Covariance
What is the formula for Co-variance?
- Covariance Formula:
- Multiply the standard deviation of asset I, by the standard deviation of asset J.
- And then multiply by the correlation between asset I and J
Numbers will be provided. Just multiply.
Real trick with covariance is understanding what it actually measures.
Used in finance to measure how 2 assets change in value in comparison to one another
YOUTUBE - FP Formulas: Covariance
What does covariance actually measure?
- Used in finance to measure how 2 assets change in value in comparison to one another
Positive – move in tandem
* Ex. Hot Summer – high temperatures, high usage of AC
Negative – move in opposite directions
* Ex. Hot Summer – sales down in coat sales, sales high for AC
YOUTUBE - FP Formulas: Covariance
Describe Modern Portfolio Theory & 2 problems with relying on covariance
Modern Portfolio Theory – portfolio managers will actually seek out negative correlated assets as a way to diversify their holdings and hedge their bets.
* When one loses, another would gain.
Two big problems with relying on covariance are:
1. Past performance does not predict future results.
2. Covariance only tells us that the 2 assets will move in the same direction.
It does not tell us how closely they will follow each other.
* One asset could increase by 5% and the other by 50% or 500%.
* Without more information, we won’t be able to make full use of that data.
That’s when we need to incorporate correlation.
What is the formula for standard deviation?
The standard deviation equals the square root of the variance.
The variance of an asset’s rates of return is a statistic that measures the asset’s __ ____??____ __.
The variance is represented by the symbols __ ____??____ __ and __ ____??____ __.
The variance of an asset’s rates of return is a statistic that measures the asset’s wideness.
The variance is represented by the symbols s2 and VAR(r).
- __ ____??____ __% probability that the actual return you will obtain next year, will be plus / or minus one standard deviation from the mean (expected return).
- __ ____??____ __% of the time, the actual return will be plus / or minus two standard deviations from the mean; and finally,
- __ ____??____ __% of the time, the actual return will be plus / or minus three standard deviations from the mean.
- These ranges (__ ____??____ __) are referred to as __ ____??____ __.
- 68% probability that the actual return you will obtain next year, will be plus / or minus one standard deviation from the mean (expected return).
- 95% of the time, the actual return will be plus / or minus two standard deviations from the mean; and finally,
- 99% of the time, the actual return will be plus / or minus three standard deviations from the mean.
- These ranges (68%, 95%, and 99%) are referred to as confidence intervals.
