9. Risk and Reward Flashcards
what is the required return?
risk free rate + risk premium
what is the risk free rate from?
gov. bond yield
what is the risk premium and how does it vary?
additional return for taking on more risk
- more risk = higher premium
What is diversification
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
What categories might you diversify?
- asset class
- sector
- location
What is another name for specific risk?
unsystematic risk
What are 4 examples of systematic risks?
- 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)
What are systematic risks?
market risk
- economic, political and global events that have an impact on markets
What are affected by systematic risks?
- liquidity
- interest rates
- inflation
- currency
What is systemic risk?
Fundamental failure within a system - could lead to a meltdown within an industry
What are 7 types of risk outside of portfolio risk?
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)
What are the two ways to quantify risk?
Forward-looking: based on forecasts and probabilities
Backward-looking; analysing historic trends or observed returns
What is the order of risk from low to high for different assets?
- bank accounts
- gov bonds
- corp bonds
- CIS
- equities
- leveraged securities eg. warrants, ETF
When are gov bonds risk free?
when held to redemption
What are hedging strategies?
Strategies to remove the price risk of an investment - but they also have an impact on performance
What are the hedging strategies for long vs short positions:
Long - short on everything except options
Short - long on everything
What are the downsides of certain hedging strategies?
Options - premium reduces performance
future/cfd - can eliminate gains on positions
what is ehm?
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)
What is passive management
Agrees w EMH
- attempts to track rather than outperform market
What is active management?
- seeks out inefficiencies in market
- attempts to outperform markets
What is seeking to outperform alpha equivalent to?
Seeking to outperform Alpha
What are the 2 methods of tracking?
- Replication
– Buying all the shares in the benchmark with the correct weighting - Synthetic
– Buying futures (or any derivatives) that represent the benchmark
What are the pros and cons of active management?
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)
What are the pros and cons of passive management?
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
What are the pros and cons of synthetic tracking?
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.
What is smart beta?
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
What are the 4 active bond management strategies?
- 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
What are the 4 passive bond management strategies?
- cash matched/dedicated portfolios: matching cash flow of bonds to liabilities
- duration matching/immunisation: matching the duration of bonds to the liability
What type of risk do passive bond management strategies avoid?
reinvestment risk
what 3 types of immunisation are there?
- Bullet immunisation – bonds with durations close to the timing of the liability.
- 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.
- 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.
What is laddering?
diversification of a bond portfolio by
maturity date
What is ESG investment also known as?
RI - responsible investing
SRI - socially responsible investing
