Chapter 1: The Investment Setting Flashcards
Time value of money in practical terms
Real risk -free rate of return. Ex. Treasury bills
3 Components to required rate of return
- Time value of money during the investment period
- the expected rate of inflation
- risk involved
Relationship between NRFR & RRFR:
NRFR = [(1+ RRFR)(1 + EI) - 1] X 100
Where
RRFR: Real rate of return
EI: Expected inflation
7 Major types of risk
- Business risk
- Political risk
- Financial risk
- Callability risk
- liquidity risk
- Convertability risk
- Currency risk
Business risk
Extent of certainty (or lack thereof) about a firms cash flows as a result of the nature of its business.
Financial risk
Financial leverage employed by the firm.
The greater the extent to which debt is used in relation to equity, the greater the financial leverage and greater the financial risk.
Liquidity risk
The effort and certainty of trading a specific investment instrument in the market.
Liquidity
The speed of a transaction as well as the price at which an investment can be sold.
Currency risk
The probability of receiving a reduced amount of domestic currency when investing in a security that makes payments in a currency other than the portfolios legal tender.
Political risk
Arises from international and domestic political risk.
Callability risk
Variability of return that derives from the possibility that bonds or preference shares may be called by the issuing firm.
Convertability risk
Possibility that the investment may be converted into the issues ordinary shares at times or under terms which prevent the investor from achieving his required rate of return.
2 Components of total risk
Systematic and non-Systematic risk
Non-systematic risk
Relates to events that affect individual companies.
Can be diversified away,
Systematic risk
Includes general economic conditions, the impact of monetary and fiscal policies, inflation, political and other events that affect all firms.
Financial risk
The probability of experiencing an event that has negative financial implications
Risk / return principle
Means that, the greater the risk, the higher the investors required rate of return.
Coefficient of variation
Measure of relative dispersion that is useful in comparing the risk of assets with differing expected returns.
Diversification
Method of reducing the unsystematic risk of a portfolio by investing in various asset classes.
2 Groups of asset classes :
- Real assets
- Financial assets
Real assets
Involve some kind of tangible asset.
Characteristics of real assets :
- Does not have the same liquidity as a financial asset.
- Information on the value is not always readily available.
Financial assets
Represent legal claims to some future benefit.
