Chapter 15 Part 5 Flashcards
Business Risk
the risk that certain circumstances or factors may have a negative impact on the operation or profitability of a given company. For example, a company may suffer due to increased competition, a decrease in demand for its goods or services, or adverse economic conditions.
Regulatory Risk
the risk that is based on regulatory changes that may have a negative impact on an investment’s value. For example, an FDA announcement denying approval of a new drug may cause a pharmaceutical company’s stock to drop in price.
Legislative Risk
the risk that new laws may have a negative impact on an investment’s value. Changes in the law can occur at any level of government and potentially can affect all sorts of investments. For example, changes in local zoning laws would greatly affect the profitability of a real estate developer.
Political Risk
“the risk that is simply defined as the risk that foreign investors will lose money due to changes that occur in a country’s government or regulatory environment. This risk is typically associated with emerging markets countries and may include acts of war, terrorism, and military coups. A milder example would be a new political party taking power and deciding to
nationalize a sector of the economy.”
Liquidity Risk
the risk that investors may be unable to dispose of a securities position quickly and at a price related to recent transactions. This type of risk tends to increase as the amount of trading in a particular security decreases. For example, the shares of large blue-chip companies are highly liquid, while the stocks of small companies are typically less liquid.
Reinvestment Risk
the risk that an investor will not be able to reinvest her principal at the same interest rate after a bond matures or is called. This situation typically occurs when interest rates are falling. The investor usually has two choices-accept a lower rate of return, or assume a higher degree of risk to keep her returns stable. reinvestment risk is also evident when an investor receives interest from a bond and reinvests at a lower rate, due to a decline in market interest rates.
Currency (Exchange-Rate) Risk
the possibility that the value of foreign investments will be less in the future due lo changes in exchange rates.
If the dollar is strengthening against foreign currencies, then U.S. goods and services will become
more expensive for foreigners. This should result in an increase in foreign goods imported into the U.S. and a decrease in the amount of U.S. goods exported to other countries. As a result, the U.S. balance of trade would worsen and the trade deficit would increase. Balance of trade refers to the difference between the monetary value of imports and exports in an economy over a certain period.
Capital Risk
risk that an investor could lose all or a portion of her investment (e.g., if the issuer defaults).
Credit Risk
also known as default risk, is the risk that the issuer will not make payments as promised.
Call Risk
risk that an issuer may decide to pay the bondholder prior to maturity. The amount paid to the bondholder may be the face value or an amount above the principal. This excess payment above par is known as the call premium.
According to the efficient market hypothesis, buying and selling securities is more a
game of chance than it is skill. If markets are efficient and current, then prices will reflect all known information; therefore, buying stocks at a bargain price is impossible. Since the prices adjust almost instantly to reflect new information, consistently outperforming the market for a significant length of time is impossible. The only way for an investor to obtain higher returns is to take on more risk. The efficient market hypothesis describes three forms of efficiency: weak, semistrong, and strong.
Weak-form efficiency asserts that
all past market prices and data are fully reflected in securities prices. Price changes result from the release of new information, which arrives randomly. However, the fact that randomly released information impacts stock prices dismisses the idea that patterns exist in the stock market. Therefore, using technical analysis would not allow investors to identify securities that are undervalued, since technical analysis attempts to discover patterns in stock price movements and then uses those patterns to predict future movements.
Advocates of weak-form efficiency believe that
fundamental analysis may be used to identify stocks that are undervalued or overvalued. Therefore, researching financial statements makes it possible to identify profitable companies.
Semistrong-Form Efficiency
This form takes the weak-form efficiency one step further by stating that security prices reflect all publicly available information (not just past information). This thery states that neither technical nor fundamental analysis would provide investors with a predictable edge. Therefore, market information, analyzed by technical traders, such as trading volume and other public financial information that fundamental analysts may consider relevant, such as earnings, dividend announcements, financial ratios, and accounting practices, does not allow investors to achieve better returns since this information is already available to every investor. Over the long term, the only way to gain an advantage in this type of market is to have access to nonpublic information.
