3. Investment Risk Flashcards
What are the 15 sources of investment risk?
Sources of investment risk?
- Systematic (Market) Non-diversifiable Risk
- Business Risk (a.k.a. Non-Systematic Risk)
- Inflation (Purchasing Power) Risk
- Interest Rate Risk
- Price Risk
- Reinvestment Rate Risk
- Credit Risk
- Liquidity Risk
- Marketability Risk
- Political Risk
- Sovereign Risk
- Exchange Rate (Currency) Risk
- Tax Risk
- Investment Manager Risk
- Additional commitment risk
What is Investment Risk?
Investment Risk?
- Pure risk – only the chance of loss or no loss
Example: auto insurance - Speculative risk – acceptance of the risk of a loss in exchange for the hoped for expected return
–also defined as the variability in an investment’s rate of return
What is Systematic (Market) Non-diversifiable Risk?
Systematic (Market) Non-diversifiable Risk – risk from events that affect all investments (the entire financial system)
1.Inflation risk and interest rate risk are components of market risk.
2.Market risk can also derive from political, economic, demographic, or social events and trends.
Example of specific market risk event: September 11, 2001 terrorist attack
What is Business Risk (a.k.a. Non-Systematic Risk)?
Business Risk (a.k.a. Non-Systematic Risk)?
Risk that comes from events that affect a single firm or small number of closely related firms
Example 1: a corporate treasurer may be accused of embezzling substantial sums of money.
Example 2: a decline in the price of imported steel.
What are the 2 factors that affect the degree of business risk?
Operating risk and financial risk are two factors which affect the degree of business risk for a company.
What is the only way to reduce business risk?
Diversification is the only way to reduce business risk.
What is Inflation (Purchasing Power) Risk?
Inflation (Purchasing Power) Risk?
- the variation in real returns caused by changes in the general level of prices.
- Inflation – when the general level of prices rise
- Disinflation – when the general level of prices fall
Which investments are most susceptible to inflation risk?
Investments most susceptible to inflation risk are fixed-income investments such as:
- savings accounts,
- CD’s,
- bonds,
- bond funds,
- life insurance cash values,
- and fixed annuities.
What is a Nominal Return and its equation?
Nominal rates are the rates we see and work with very day.
Equation: Nominal rate = (1 + real rate) * (1 + inflation rate) – 1
Note: subtracting 1 reflects a return of principal.
Example of nominal return:
Jeff Robins tells his financial planner that he wants to earn a 10 percent rate of return because he wants a 4 percent real rate of return and he expects a 6 percent inflation rate. The financial planner should advise Jeff that he is mistaken about what he needs to earn.
Nominal rate = (1 + real rate) * (1 + inflation rate) – 1
Real rate = 0.04
Inflation rate = 0.06
(1 + .04) * (1 + .06) 1 = .1024, or 10.24%
Jeff actually needs a 10.24 percent nominal rate of return based on his goal and his inflation expectation.
What is the Real (Inflation-Adjusted) rate?
Real rate =[(1 + nominal rate) / (1 + inflation rate)] - 1
What is Interest Rate Risk?
Interest Rate Risk?
Interest rate risk refers to the degree to which an investment is affected by changes in interest rates.
What are the 2 components of interest rate risk?
2 components of interest rate risk:
- Price Risk – refers to the fact that any change in market interest rates typically leads to an opposite change in the value of investments—when interest rates rise (fall), the value of an investment declines (increases).
Example: instruments that have a contractually specified rate or return such as bonds.
- Reinvestment Rate Risk – the risk related to what the interest rate will be when income and/or principal from
investments is revinvested.
Example: If rates fall, a bondholder may not get as high of a return as previously and thus he will earn less if he reinvests.
What is Credit Risk?
Credit Risk?
- a.k.a. default risk
- the risk that contractual payments on debt securities will not be honored.
What is Liquidity risk?
Liquidity risk refers either to the inability to sell an asset quickly, or the need for a price concession to sell quickly.