Chapter 5 (5 marks) – The Nature And Impact Of The Main Types Of Risk On Investment Performance Flashcards
What is inflation risk?
Inflation is measured by
Retail Prices Index (RPI)
Consumer Prices Index (CPI)
Consumer Prices Index Housing (CPIH)
Tell me the differences between each
Which index above is the official measure which is used by the BOE
Retail Prices Index (RPI) which has no official or government measurement attached to it, but is still important for many investment plans.
Consumer Prices Index (CPI) which excludes mortgage and housing costs is still the one used by the Bank of England as their target.
Consumer Prices Index Housing (CPIH) which is in effect the most relevant measure of inflation in the UK
CPI is still the official measure. Currently, the Bank of England has been tasked with manipulating interest rates in order to meet a 2% CPI-measured inflation target. As of July 2023 it is 7.9%!
One of the main measures of risk within bonds is their duration, which is really their sensitivity to movements in interest rates.
A portfolio manager, in charge of a fixed-interest portfolio, could look to reduce their interest rate risk by holding shorter-dated stock or cash.
Tell me some factors that cause interest rate movements
There are many forms of credit risk that can affect bonds and cash deposits.
There are:
Bail-in risk
Counterparty risk
Credit spread risk
Downgrade risk
Default risk
Tell me about each
Bail-in risk
Where a firm (usually a bank) in trouble receives financial help from its existing capital base, i.e. its shareholders, depositors, and holders of bonds. This ‘help’ results in the value of their shareholdings being reduced A bail-in is the opposite of a bail-out, which is where a financial institution receives help from external parties.
Counter party risk
This is the risk that the ‘counterparty’ will not pay what it is obliged to on a bond, derivative or other transaction
Credit Spread Risk -
This is the risk that the gap between the yields of GILTS and those of corporate bonds gets wider, due to a lack of confidence in corporate bonds. Widening credit spreads indicate growing concern about the ability of corporate borrowers to service their debt. Narrowing credit spreads indicate improving private creditworthiness
Downgrade risk
This is the risk that the market expects a credit rating agency downgrade to occur, or a downgrade does occur. When a downgrade occurs, the value of the bond reduces. For example a company goes from a triple AAA rating to AAB . This has the effect of increasing its yield, to automatically reward the investor for the added risk taken
Default risk -
This is the risk that that the value of a fixed-interest investment will fall due to investors deciding that the company is more likely to default on its liabilities. A company’s credit rating is a good indicator of the likelihood of default.
What is the difference between a bail-in and a bail-out in relation to a firm that needs financial help
Bail-in:
Where a firm (usually a bank) in trouble receives financial help from its existing capital base, i.e. its shareholders, depositors, and holders of bonds.
Bail-out: Where a firm receives financial help form external parties
What is event risk?
Risk caused by events such as Natural disasters, takeovers and regulatory change
Japanese firms suffered from the earthquake in 2012 with many companies being unable to pay interest or repay capital.
What is operational risk?
Risk caused by internal issues within companies. Those that affect investments include:
Fraud; both internal and external.
Misrepresentation; misleading valuations or reports. Staff errors etc
What is shortfall risk?
Involves an investment element
Where your investment doesnt preform as desired so resulting in a short fall. Can be bad for interest only mortgages
See image for many types of risk that can affect investments
I have left out the obvious ones above
Does diversification prevent systematic risk?
NO, nothing can prevent systematic risk
What is gearing?
What is it also known as?
What are the advantages and disadvantages of this?
where investors borrow money to purchase investments
It is also known as leverage
Advantages:
Investors can take advantage of investment opportunities, such as right issues from companies or to purchase shares that they feel are undervalued
Disadvantages:
Gearing can magnify losses because now it also included borrowed money, it creates an interest liability for the fund, and adds risks to the funds.
What is leverage?
Just another name for gearing
where investors borrow money to purchase investments
What are rights issues?
where companies offer further shares to existing shareholders often at a discount
What is systematic risk and why cannot it be removed through diversification?
What is non-systematic risk, and how does it differ from systematic risk?
Why is inflation considered a major risk to investors, particularly for cash and fixed-interest investments?
Which types of real assets are considered effective in beating inflation?
How is interest rate risk measured, and what does a higher bond duration imply about its sensitivity to interest rate changes?
What additional risk is generated by overseas investments?
What are operational risks, and where do they typically originate within a company?
What is shortfall risk, and how does it impact an investor’s ability to reach a target sum in the future?
What is diversification, and how does it reduce the overall risk of a portfolio?
What are the different levels or ways through which diversification can be conducted?
What is gearing in the context of investment funds, and how does it affect risk and growth potential?
What is systematic risk and why cannot it be removed through diversification?
Systematic risk, also known as market risk, affects the entire market and cannot be eliminated through diversification because it impacts all investments across the board.
What is non-systematic risk, and how does it differ from systematic risk?
Non-systematic risk, or investment-specific risk, is unique to a particular company or industry. Unlike systematic risk, it can be mitigated through diversification.
Why is inflation considered a major risk to investors, particularly for cash and fixed-interest investments?
Inflation erodes the purchasing power of money over time, making cash and fixed-interest investments less valuable as their returns may not keep up with the rising cost of goods and services.
Which types of real assets are considered effective in beating inflation?
Real assets such as property and equities are considered effective in beating inflation because they tend to appreciate in value over time, often at a rate that outpaces inflation.
How is interest rate risk measured, and what does a higher bond duration imply about its sensitivity to interest rate changes?
Interest rate risk is measured by duration. A higher bond duration means the bond is more sensitive to changes in interest rates, implying greater price volatility when interest rates fluctuate.
What additional risk is generated by overseas investments?
Overseas investments generate currency risk, which arises from fluctuations in foreign exchange rates that can affect the value of investments.
What are operational risks, and where do they typically originate within a company?
Operational risks are risks arising from a company’s internal functions, including processes, systems, and people.
What is shortfall risk, and how does it impact an investor’s ability to reach a target sum in the future?
Shortfall risk is the risk that an investment underperforms expectations, causing the investor to fail to reach a target sum or amount in the future.
What is diversification, and how does it reduce the overall risk of a portfolio?
Diversification is the process of combining different risky investments in a way that reduces the overall risk of the portfolio. By spreading investments across various assets, sectors, or geographies, the negative performance of one investment can be offset by the positive performance of others.
What are the different levels or ways through which diversification can be conducted?
Diversification can be conducted through different asset classes (e.g., stocks, bonds, real estate), different geographies (e.g., domestic vs. international), and different sectors (e.g., technology, healthcare, finance).
What is gearing in the context of investment funds, and how does it affect risk and growth potential?
Gearing is the process by which a fund or investment method borrows money to invest in additional fund assets. It magnifies both potential losses and potential gains, thus increasing the overall risk but also providing the possibility for higher growth.
