7. Risk

Question 1

“Risk can be defined as the possible variation in an outcome from what is expectedto happen.”

This definition of risk contains three important elements:

Answer 1

— Risk is about variability because future events cannot be predicted with certainty.

— Risk relates to our expectations of what will happen.

— Risk arises because what actually happens could differ from what is intended or expected to happen.

Question 2

Stock‑market‑linked investments are termed…

Answer 2

‘asset‑backed’ investments
* Because their value is backed by the value of the assets underlying the shares or investment.

Over the longer term, asset‑backed investments are more likely to provide protection against inflation.

Question 3

What does the term equity risk premium (ERP) refer to?

7.2 The equity risk premium

Answer 3

The equity risk premium (ERP) refers to the difference in returns between equities and low-risk investments like government bonds, compensating for the higher risk of investing in equities.

A measure of risk vs reward

Question 4

At a high level, risk can fall into one of several categories… Investment risk

Answer 4

the probability/likelihood of achieving/failing to achieve the
expected return on any particular investment;

Question 5

At a high level, risk can fall into one of several categories… operational risk

Answer 5

risk of losses stemming from inadequate or failed internal
processes, people and systems, or from external events;

Question 6

At a high level, risk can fall into one of several categories… business risk/reputational risk

Answer 6

the exposure that a company has to factors that will lower its profits/earnings.

Question 7

Name 9 types of risk that relate to investments

Answer 7

• Captial risk
• income risk
• shortfall risk
• liquidity and access risk
• interest risk
• inflation risk
• currency risk
• systematic and non-systematic risk
• Gearing.

Question 8

What is captial risk?

Answer 8

The risk of losing some, or all, of the original capital invested.

Deposit-based accounts reduce this risk, but are prone to inflation risk

Question 9

hat

What is Income risk

Two forms?

Answer 9

1. Income generated will not keep pace with inflation
   * Particularly with the case with fixed-income vehicles like annuities and fixed-interest gilts
2. Income from an investment will reduce in notional terms
   * Particularly with investmens that have a variable rate of interest
   * Or when a company reduces dividends paid on shares

Question 10

What is shortfall risk?

Give an example

Answer 10

A risk based out of expectations

If the investment has been taken out for a specific purpose and it does not achieve it’s goal.

Example: Endowments taken out to support an interest-only mortgage - the endowment may not perform well enough to cover the mortgage amount at maturity

Question 11

What is liquidity risk?

Answer 11

• Ease and time taken to access to funds
• Price of the asset can be a factor - property for example, limits the total amount of potential buyers

Question 12

What is interest risk?

two ways its shows

Answer 12

• Savers in variable-rate accounts run the risk that their interest rate will reduce - and no longer provide the income they desire
• Fixed interest savings accounts with penalites may receive a lower rate relative to market if rates increase - unable to withdraw without penalty

Question 13

what is inflation risk?

Answer 13

Inflation errodes the true buying power of an asset or fund over time.

Investors should look for investments that are likely to provide a real return over time.

Borrows actually tend to benefit from higher inflationary rates, as the the ‘real’ value of their debt reduces over time.

Question 14

What is currency risk?

Check example on page 250

Answer 14

Where an investment is made overseas or in a fund that invests overseas, there is currency risk: the risk that currency fluctuation might erode the value of the investment.

When sterling rises in value against the foreign currency, it has the effect of reducing the value of the investment in sterling terms. Conversely, when sterling falls against the foreign currency, the value of the investment rises in sterling terms.

Question 15

What is Systemic risk?

Answer 15

Systemic risk in banking is a risk that affects the entire financial market or system, not just specific participants.

The main sources of concern for systemic risks are banking and insurance.
* Banks are highly geared – they have large amounts of liabilities relative to the amount of their own capital.
* There is a high need for liquidity.
* There is high interdependence between banks
* Potential for a ‘run’ on the banks, leading to large withdrawals of money by customers.

Question 16

What is Systematic risk?

Answer 16

Known as market risk

Systemic risk begins with the impact on a specific business or group of businesses and spreads through the wider market because of the interlinkages between businesses.

Systematic risk springs from an event external to the market that affects the entire market.

Question 17

What is non-systemic risk?

How can non-systemic risk be mitigated by an investor?

Answer 17

Non‑systematic risk relates to specific sectors and investments. It is the risk of a
particular share failing to deliver expected returns, or collapsing due to factors more to do with the company or companies in a specific sector than the markets or economy in general.

Non‑systematic risk can be diluted by diversifying the portfolio over a number of
companies’ shares, or over a number of market sectors.

Question 18

What is gearing risk?

Which financial instrument is gearing particularly relevent to?

Answer 18

Gearing is where a company borrows to invest.
* Gearing is usually expressed by showing the borrowing as a percentage of capital and resvers.
* Sometimes referred to as leverage

The higher the proportion of debt to the capital and reserves of the company, the more volatile the investment.

Particularly relevant to investment trusts

Question 19

Gearing explained?

Answer 19

The investment trust manager borrows the funds to buy assets that they feel are likely to increase in value

As a result of the initial purchase, the fund will see an initial rise in asset value, created by the additional assets.

if the assets grow at a higher rate than the interest paid on the borrowing, the investor wins through increased dividends, share price or net asset value (NAV).

Question 20

Defined Net asset value (NAV)

Answer 20

The value of the investment trust’s assets, less liabilites, divided by the number of shares.

Gearing increases the volatility of the investment, because the effect of a fall in the value of assets bought with borrowing will be made worse by the effect of the interest payments on the overall picture

Question 21

Volatility

How is it measured? give example how this can be shown on share return

Answer 21

A measure of how much the value of a share or fund fluctates over a set period, when compared with its previous performance, and to an average of its sector or specified benchmark

Measured by its standard deviation from the average or benchmark return (Known as the ‘expected return’

• If a shares value stays close to the expected return, it is said to have low volatility
• For example, returns from an investment with a standard deviation of 1 and an expected return of 5% would be expected to fluctuate between 4% and 6% presenting low volatility

Question 22

General rule regarding volatility and a normal distribution curve

Answer 22

• 68 per cent of the data is contained within 1 standard deviation of the mean (benchmark),
• around 95 per cent within 2 standard deviations
• and almost 100 per cent within 3 standard deviations.

To give an example, if a share has an expected return of 10 per cent and a standard deviation of 15 we can predict that:
* roughly 68 per cent of the time the return will be within one standard deviation – minus 5 to plus 25 per cent;
* roughly 95 per cent of the time the return will be between two standard deviations – minus 20 per cent to plus 40 per cent
* 99 per cent of the time the return will be between three standard deviations – minus 35 per cent to plus 55 per cent.

Question 23

What are Beta factors?

7.4.2 Measures of volatility

Answer 23

Beta factors measure the volatility of a share or collective fund against the whole market or against a benchmark such as a specific FTSE index.

The beta measures are:
* beta factor 1 – where the holding moves in line with the index or benchmark, which is assumed to have a beta of 1

• beta factor over 1 – where the holding fluctuates more widely than the benchmark, making it more volatile and more risky than the benchmark;
• beta factor below 1 – where the holding fluctuates less than the benchmark.

A cash‑based investment has no direct links with the stock market and so would have a beta close to 0.

The higher the beta, the more volatile and risky the investment. Even where the investor has diversified the portfolio, if the average beta of the investments in the portfolio is above 1, the portfolio is riskier than the market in general.

Question 24

Formula for calculating the alpha

Answer 24

AR – {RF + FB (RM‑RF)}
AR = actual fund return
RF = risk‑free return
FB = fund beta
RM = market return

Question 25

Alpha performance measurement

Answer 25

Alpha is a term used to measure an asset’s return on investment compared to the risk‑adjusted expected return.
* the expected return is based on a benchmark, which is usually an index

Question 26

What does a positive alpha show?

Answer 26

If the return from an investment is higher than the benchmark’s risk-rated return, it has a positive alpha

This means that the additional risk is worth takin

Question 27

What does a negative alpha show?

Answer 27

The return from the investment is lower than the benchmark - the risk is not worth taking

Question 28

What is the time value of money

Answer 28

The time value of money means that money received today is more valuable than the same amount in the future due to its earning potential. Money received now can be invested to generate returns, so future payments must offer compensation for the delay.

• £1 today could be invested at 5%, it would be worth £1.05 in 12 months - £1.05 would be its future value.
• Similarly, a promise of £1.05 in 12 months time would have a present value of £1.

Question 29

Compound and simple interest?

The time value of money

Answer 29

Simple interest is the term used when interest added to an investment is based on the
original capital each year.
Example - £1000 with 4% interest would be:
* £1040 in the first year, paid on the anniversay
* £1080 in the second year, paid on the anniversary.

Compound interest is the term used when interest earned is added to the **capital and
earns interest itself. **
Example - £1000 with 4% interest compounding:
* £1040 in the first year
* £1081.60 in the second year
* £1124.86 in the thrid

Question 30

What is Discounting

What can it be used for?

Answer 30

Discounting is the opposite of compounding, and can also be calculated using compound
interest tables.

Discounting is used when we need to work out how to invest now in order to achieve a target sum in the future.

Example: Investor needs £15,000 in 8 years time. They think they can achieve 6% per year from their investments. Using compound interest tables to find the ‘single unit principle’ factor - 1.59385

£15,000/1.59385 = £9,411.17 to achieve this goal.

Question 31

Explain Pound cost averaging

Reverse Pound cost averaging?

Answer 31

Pound cost averaging is an investment strategy where an investor spreads their investment over time by regularly purchasing assets in smaller instalments, rather than investing a lump sum all at once.

• Mitigates the risk of market volatility by averaging out the purchase price of the assets.
• One drawback is that it may temporarily affect the asset allocation of a portfolio until fully invested.

Reverse pound cost averaging is withdrawing funds a different stages to take advantage of different price points in the mark - averaging returns and reducing volatility.