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J10 - Discretionary Investment Management > 9. Investment Returns and Risk > Flashcards

9. Investment Returns and Risk Flashcards

1
Q

A. Investment risk (pages 2 & 3)

A

Each category of asset has a potential role to play within a client’s overall investment portfolio.

Equally, different types of investment are more or les risky in different circumstances:

  • cash and fixed-interest securities are vulnerable to the effects of inflation
  • in economic downturns, equities are generally losers
  • in periods of declining interest rates, cash is seen as unattractive where as fixed-interest bonds and equities are often more appealing

In finance, ‘risk’ is neutral. It refers to the outcome being different than expected.

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2
Q

A. Investment risk (pages 2 & 3)

CONTINUED

A

Risk can be categorised in different ways, but Modern Portfolio Theory (MPT) categorises risk as being one of two ways:

  1. SYSTEMATIC (MARKET) RISK
    - risk that there might be a reduction in the expected return as a result of a fall in the stock market
  2. NON-SYSTEMATIC (INVESTMENT SPECIFIC) RISK
    - risk that there might be a reduction in the expected return as a result of some event or circumstance specific to a particular company
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3
Q

A. Investment risk (pages 2 & 3)

CONTINUED

A

Main types of risk:

  • capital risk
  • income risk
  • interest rate risk
  • inflation risk
  • currency risk
  • shortfall risk
  • systematic and non-systematic risk
  • long-term returns and volatility

FAIR RETURN
- one that compensates the investor for the risk incurred in making the investment

EXCESS RETURN
- one that over-compensates the investor for the risk incurred

Investors want to avoid investments that pay less than a fair return.

Borrowers want to avoid paying an excess return.

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4
Q

B. Types of investment risk (page 3)

B1. Capital risk (page 3)

A

There are a number of different risks to capital that need to be considered.

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5
Q

B1A. Credit risk (page 3)

A

Particularly important for investors in bonds or those placing deposits with financial institutions.

Three types:

  1. Default risk (risk that an issuer will default on their obligations to pay interest and capital on maturity)
  2. Downgrade risk (the risk that the market anticipates that a credit rating agency is going to downgrade a bond)
  3. Credit spread risk (the widening yield between different grades of bonds as a result of nervous investors moving to higher quality bonds)
    - bonds issued by companies tend to underperform those issued by governments
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6
Q

B1B. Event risk (pages 3 & 4)

A

This is where the company experiences an ‘event’ such as a restructure or merger which causes uncertainty within investors.

Event risk also includes natural catastrophe risk, including the risk of earthquakes, floods etc.

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7
Q

B1C. Counterparty risk (pages 4 & 5)

A

The risk that the organisation with which an investment is placed, or the counterparty to the transaction, will fail.

UK BANKS AND OTHER DEPOSIT-TAKERS

  • Protection offered via the FSCS (£85,000)
  • Lower-ranked banking institutions have to offer higher interest-rates to attract deposits, placing them at potentially greater risk
  • Greater degree of comfort offered by having the Prudential Regulation Authority who supervise deposit-taking institutions
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8
Q

B1C. Counterparty risk (pages 4 & 5)

CONTINUED

A

GOVERNMENT AND CORPORATE BOND ISSUERS

  • Bonds issued by leading Western governments are usually considered free of default risk
  • Many smaller countries are not as reliable and investors may require considerable additional return or premium to induce them to invest

FUND MANAGERS AND INSURANCE COMPANIES

  • FSCS provides protection of up to £85,000 for investments
  • 100% protection for general insurance business
  • 90% for all other types of insurance
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9
Q

B1D. Gearing (page 5)

A

Gearing is borrowing money to increase exposure to other assets. It magnifies the possible positive and negative portfolio returns.

Can also be deployed synthetically via futures and options.

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10
Q

B1E. Liquidity risk (page 5)

A

This is the risk of having to sell at a lower price because of a lack of liquidity.

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11
Q

B2. Income risk (page 5)

B2A. Cash deposit income (page 5)

A

Deposit holders receive no compensation in terms of rising capital values when interest rates fall, unlike bond holders.

Also subject to full tax over personal allowances.

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12
Q

B2B. Bond income (pages 5 & 6)

A
  • Bonds pay a fixed income

However:

  • the return is fixed and falls by inflation
  • fixed rate is uncompetitive if interest rates rise

Some bonds provide protection against inflation but at a cost:

  • index-linked bonds have lower yields
  • floating rate bonds offer rates that match benchmarks but now tend to be issued by companies with lower credit rating
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13
Q

B2C. Dividend income (page 6)

A

Dividends from shares can fluctuate as companies alter their dividend pay-out to shareholders.

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14
Q

B2D. Property income (page 7)

A

Rent varies with market conditions.

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15
Q

B3. Interest rate risk (page 7)

A

FALL IN INTEREST RATES: Capital values rise
RISE IN INTEREST RATES: Capital values fall

Key Factors to Interest Rate Changes:

ECONOMIC CYCLE - boom will show high rates where as in a recession rates will be lower
GOV FISCAL POLICY - gilts issues push up medium-long-term gilt yields
GOV MONETARY POLICY - QE tends to reduce short term rates
INFLATION EXPECTATIONS - if inflation is expected to increase, this will push up longer term interest rates
PREFERENCE FOR LIQUID SECURITIES - in times of uncertainty, investors prefer to hold their money in short-term securities, pushing down short-term interest rates

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16
Q

B4. Inflation risk (pages 7 & 8)

A

Key Meansures of Inflation:

  • CPI (Government’s key measure for inflation and the BoE aims for 2% per annum)
  • CPIH (CPI plus owner occupier housing costs, therefore more comprehensive as includes costs of owning and occupying a house)
  • RPI (was the main measure for inflation in the UK but does not meet the standards for designation as a national statistic)
17
Q

B4. Inflation risk (pages 7 & 8)

CONTINUED

A

Inflation can be caused by many things, such as rising demand fuelled by expanding money supply which leads to the following:

  • bottlenecks in production cause prices to rise
  • government and financial markets respond with rising interest rates
  • cuts in public expenditure and rises in taxation to dampen demand
  • economy enters recession and prices steady or even fall as supply exceeds demand
18
Q

B4. Inflation risk (pages 7 & 8)

CONTINUED

A

Some cycles of further exacerbated by external events such as:

  • war or shortages
  • prices of imported goods rising as overseas countries experience inflation
  • currency devaluation
  • high wage demands

Investor sentiment can also be an important contributor.

19
Q

B4A. Inflation (pages 8 & 9)

B4B. Inflation protection (page 10)

A
  • Higher inflation leads to savings looking worse because of the lack of a ‘real rate of return’
  • It encourages people to spend rather than save in deposits, and boosts the economy, reducing debt for borrowers (companies and the Government)
  • investing in real assets such as property, commodities, infrastructure or shares can help beat inflation
  • as can using index-linked securities
20
Q

B5. Currency risk (page 11)

A

The value of stocks can rise and fall as a result of currencies strengthening and weakening.

For example, if £ is strong against the $ any capital growth can be eliminated when investing in US stocks.

Individual securities can also be affected.

If you invest in a company that is dependent on exporting, and the currency where the goods are manufactured appreciates, then the profitability of the company is affected.

21
Q

B6. Shortfall (page 11)

A
  • The rist that an investor may not acheive their investment target
  • In investment management, it is the risk of the portfolio not reaching a certain threshold
22
Q

B7. Long-term returns and volatility risk (pages 11 & 12)

A

A shortfall could mean that an investor needs to choose between:

  • reducing the target amount
  • increasing the amount saved each month
  • increasing the term of the investment

Various ways of reducing the impact of volatility:

  • long-term flexible investment periods
  • pound-cost averaging

DRAWDOWN - used to illustrate the extent to which volatility can impact a fund value

23
Q

B8. Systematic and non-systematic risk (page 12)

B8A. Systematic risk (page 12)

B8B. Non-systematic risk (page 12)

A

SYSTEMATIC RISK:

  • the disruption caused to the financial system by an event such an an economic shock
  • causes a chain reaction leading to price volatility, losses or market failure

NON-SYSTEMATIC RISK:
- the risk of a single financial instituion failing

24
Q

C. Quantifying risk (pages 12 & 13)

A

We need to be able to identify the ‘risk premium’, which is the extra reward required by investors to compensate for the perceived risk.

25
Q

Chapter 9 Key Points (page 14)

A

INVESTMENT RISK:
- all assets experience some sort of risk, even risk-free ones

MAIN TYPES OF RISK:

  • capital risk
  • income risk
  • interest rate risk
  • inflation risk
  • currency risk
  • shortfall risk
  • volatility risk
  • systematic and non-systematic risk

TYPES OF INVESTMENT RISK:

  • Default Risk (risk that the issuer will default on their obligations to pay interest and capital)
  • Liquidity Risk (risk that an investment may not be readily realisable and therefore forced to sell at an inconvenient time)
  • Inflation Risk (rises in prices will erode the real value of financial assets)
  • Shortfall Risk (relates to the risk that an investor might not acheive their financial target)
  • Systematic and Non-Systematic Risk (risks that can be encountered when there is a disruption to the financial system)

QUANTIFYING RISK:
- Risk premium can be defined as the extra reward required by investors to compensate for perceived uncertainty in the expected return

J10 - Discretionary Investment Management (15 decks)

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