Chapter 6: Investment risk Flashcards
Define inflation
An overall upward price movement of goods and services in a economy
What is the ‘nominal’ return
The return an investment gives without adjusting for inflation
What is the ‘real’ return
The return from an investment after considering inflation
Formula for real rate of return
1 + RROT = (1 + Nominal Rate)/(1 + Inflation Rate)
What is total return
The returns on an investment both from its income production, and any other capital gains (or losses) that it generates
What is holding period returns
The total return on an asset or portfolio over the period during which it was held.
How do you calculate holding period returns
The sum of income over a particular period, divided by the initial period value
formula for compound interest
s= x(1 + r)^n
what is present value
the amount of money which must e invested now for n years at r% interest to earn a given future sum of money
What is currency risk
The risk arrising from fluctuations in the value of currencies against one another
what is interest rate risk
The risk that interest rates move against the investor
What is issuer risk
The risk that the bond issuer, whether government or corporate, gets into financial trouble and cannot keep up with interest payments, or defaults on the final payment
What types of risk contribute to equity risk
Liquidity risk, growth risk, volatility risk, strategic risk
What is growth risk
the risk that, if investing for growth, the company may not grow as expected
What is volatility risk
The risk that the performance of an investment can change quickly, in either direction over a short period of time.
What is commodity risk
The risk of an adverse price movement in the value of the commodity
What is property risk
Location of the property
the effect of the use of the property on its value
the credit quality of the tenants
the length of the lease
What is Liquidity risk
Liquidity risk refers to the likelihood of being unable to transform assets into cash
Examples of an investments fund benchmark
Performance of peer group funds
relevant market index
What is the beta factor
Measures the volatility on an investment relative to the market or benchmark
Beta factor of 1 moves in line with the market
Beta factor > 1 varies more widely than the market
Beta factor < 1 varies less than the market
Over what time period are beta factors calculated
36 months
What is alpha factor
Used when assessing the performance of a fund or portfolio, and refers to the extent of any outperformance against the benchmark
What is a disadvantage of alpha
Does not distinguish between underperformance caused by incompetence and underperformance caused by fees
What is the Sharpe ratio
Uses a concept called ‘risk free return’. This risk free return rate is the rate that it is assumed can be obtained by investing in financial instruments with no default risk.
The Sharpe ratio measures the excess return of a portfolio over the risk-free interest rate, for each unit of risk assumed by the portfolio
Sharpe ratio formula
((Return on the portfolio) - (Risk free return))/Standard deviation of portfolio
What does a high Sharpe ratio mean
The higher the Sharpe ratio, the better risk adjusted performance of the portfolio, and the greater implied level of active management skill
What is the information ratio
Compares the excess return achieved by a fund over its benchmark, to the funds tracking error (Tracking error is its standard deviated compared to benchmark)
Information ratio formula
Mean of excess returns/Standard deviated of excess return from benchmark
What is private equity
An illiquid asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange
Advantages of private equity
Potential for higher returns and lack of correlation to ‘standard’ investment
What is venture capital
A type of private equity, typically provided to early-stage, high-potential, growth companies in the hope of generating a return through an eventual sale of the company once it has become successful
Advantages of venture capital
Tax advantages - typically tax relief is given on the investment
Potential for higher returns then can be achieved by mature companies
Lack of correlation with more standard investment
What is responsible investment
RI began as a niche investment area, serving the needs of those who wished to invest ethically. In recent years it has become much more popular
What is asset allocation
The macro equivalent of diversifying a portfolio to reduce risk
What is tracking error
A measure of how closely a portfolio follows the index to which it is benchmarked, and it can be calculated either as a historical or a predicative indicator. Tracking error is ‘realised’ or ‘ex post’ while predictive tracking error is ‘ex ante’
What is an investment mandate
It is set out by the investment manager’s company and determines the fund’s aims, the limits within which it is supposed to invest, and the investment policy it should follow
What is optimisation
Often referred to as mean-variance optimisation, it is the construction of techniques to obtain the best expected returns from the riht mix of correlations and variances
What is hedging
Hedging is a means of reducing the risk of adverse price movements by taking an offsetting position in a related product. It is a means of insuring against market risk
What are the four main areas where a portfolio will benefit from monitoring, management and reporting
Peer review with other internal fund managers
Risk review with internal independent fund manager s
Monitoring for mandate compliance
Performance attribution reporting
