9. Risk and Reward

Question 1

what is the required return?

Answer 1

risk free rate + risk premium

Question 2

what is the risk free rate from?

Answer 2

gov. bond yield

Question 3

what is the risk premium and how does it vary?

Answer 3

additional return for taking on more risk

• more risk = higher premium

Question 4

What is diversification

Answer 4

investment technique to optimise risk/reward trade off

• combine securities that are not perfectly positively correlated
• avg risk decreases with higher number of assets
• removes specific (unsystematic) risk focuses more on market risk

Question 5

What categories might you diversify?

Answer 5

• asset class
• sector
• location

Question 6

What is another name for specific risk?

Answer 6

unsystematic risk

Question 7

What are 4 examples of systematic risks?

Answer 7

• business risks (are products succesful or no; strikes?)
• industry risks
• management risks (calibre of management)
• financial risks (relative to level of debt financing in cap structure)

Question 8

What are systematic risks?

Answer 8

market risk

• economic, political and global events that have an impact on markets

Question 9

What are affected by systematic risks?

Answer 9

• liquidity
• interest rates
• inflation
• currency

Question 10

What is systemic risk?

Answer 10

Fundamental failure within a system - could lead to a meltdown within an industry

Question 11

What are 7 types of risk outside of portfolio risk?

Answer 11

inflation risk - inflation will erode purchasing power of assets

interest rate risk - change in interest rates will affect prices (bad for bond traders)

reinvestment risk - changes in interest rates will affect reinvestment returns (bad for bond holders)

default risk

liquidity risk

exchange rate risk (when investing overseas)

political and legal risk (esp relevant when investing overseas)

Question 12

What are the two ways to quantify risk?

Answer 12

Forward-looking: based on forecasts and probabilities

Backward-looking; analysing historic trends or observed returns

Question 13

What is the order of risk from low to high for different assets?

Answer 13

• bank accounts
• gov bonds
• corp bonds
• CIS
• equities
• leveraged securities eg. warrants, ETF

Question 14

When are gov bonds risk free?

Answer 14

when held to redemption

Question 15

What are hedging strategies?

Answer 15

Strategies to remove the price risk of an investment - but they also have an impact on performance

Question 16

What are the hedging strategies for long vs short positions:

Answer 16

Long - short on everything except options

Short - long on everything

Question 17

What are the downsides of certain hedging strategies?

Answer 17

Options - premium reduces performance

future/cfd - can eliminate gains on positions

Question 18

what is ehm?

Answer 18

The efficient markets hypothesis

• in an efficient market all information about assets is freely available, correctly interpreted and are properly priced on markets (all assets reflect true value)

Question 19

What is passive management

Answer 19

Agrees w EMH

• attempts to track rather than outperform market

Question 20

What is active management?

Answer 20

• seeks out inefficiencies in market
• attempts to outperform markets

Question 21

What is seeking to outperform alpha equivalent to?

Answer 21

Seeking to outperform Alpha

Question 22

What are the 2 methods of tracking?

Answer 22

• Replication
  – Buying all the shares in the benchmark with the correct weighting
• Synthetic
  – Buying futures (or any derivatives) that represent the benchmark

Question 23

What are the pros and cons of active management?

Answer 23

Pros:

• choice of investments; can exploit less efficient segments of market; can avoid specific (riskier) sections of market
• higher than market return

Cons:

Key person risk
- manager may move on
- manager may make bad choices

• costs (more expensive)

Question 24

What are the pros and cons of passive management?

Answer 24

Pros:
- reflects market as whole; diversified portfolio, collective opinion

• cheaper

Cons:

• lack of control over individual investments

return equal market returns in bad times too

no chance for alpha

Question 25

What are the pros and cons of synthetic tracking?

Answer 25

Pros: may reduce costs and any possibility of tracking
error

Cons: exposes the investor to the risk of the derivative provider being
able to meet their obligations.

Question 26

What is smart beta?

Answer 26

Instead of using a market index, smart beta funds will use alternative weighting methods, such as dividends paid, sales revenue or cash flow
generated.

Once the benchmark is created, it is tracked passively

Question 27

What are the 4 active bond management strategies?

Answer 27

• anomaly switching: exploiting mispricing in the bond market
• policy switching: exploiting market shifts caused by interest rates movements etc.
• inter-market switch: trading on the spread between a bond and its benchmark
• riding the yield curve: buying a longer term bond than required and selling before maturity

Question 28

What are the 4 passive bond management strategies?

Answer 28

• cash matched/dedicated portfolios: matching cash flow of bonds to liabilities
• duration matching/immunisation: matching the duration of bonds to the liability

Question 29

What type of risk do passive bond management strategies avoid?

Answer 29

reinvestment risk

Question 30

what 3 types of immunisation are there?

Answer 30

1. Bullet immunisation – bonds with durations close to the timing of the liability.
2. Barbell immunisation – bonds that have equal weightings either side of the liability. E.g. 10 year liability met with 50% 8 year duration bonds and 50% 12 year duration bonds.
3. Ladder immunisation – a variety of bonds with different durations either side of the liability. The weighted average duration will be the same as the
   liability.

Question 31

What is laddering?

Answer 31

diversification of a bond portfolio by
maturity date

Question 32

What is ESG investment also known as?

Answer 32

RI - responsible investing

SRI - socially responsible investing