Chapter 6: Investment Risk Flashcards
what is nominal returns?
returns unadjusted for inflation
what are real returns?
return an investment provides after stripping the effects of inflation
how is the real rate of return calculated?
(1+real rate of return) = 1+nominal rate of return/(1+inflation rate)
what are total returns?
returns on investment from both income productions (dividends) and any capital gain
what is the holding rate of return?
return on an asset or portfolio over the period with which it was held
how do rates of return on asset classes vary?
volatility for equities is usually much higher than fixed income securities, longer the available time the more can be invested into equities
what is currency risk?
risk arising from fluctuations in the value of currencies against one another
what is interest rate risk?
risk that interest rates move against one another, can also affect investors capital in terms of fixed income securities
what is issuer risk?
risk that the bond issuer gets into financial difficulties and cannot keep up interest payments or defaults on the final repayment
what risk factors affect the riskiness of investment in shares?
- liquidity, growth, volatility, strategic risk of the institution
what is growth risk?
whether the investors shares rise in price and will the company make enough profits to pay steady and rising dividends
what is the reward that can be gained from taking on growth risk?
if the company does very well, investors may make large capital gains with no ‘cap’ on how high these could be
what strategic risks are companies subject to?
- industry and cyclicality
- competence of management
- financial soundness of the company
what are the distinguishing features of property?
- subjective nature of valuation
- high up front costs
- complex legal considerations
what risks are associated with property?
location, use of the property on its value, credit quality, length of the lease
what market factors affect property risk?
changing interest rates, performance of individual property sectors, prospects for rental income growth
what is liquidity risk concerned with?
ease with which investment assets can be: sold for cash, used as collateral to secure cash flows
how is investment risk usually measured?
measured in terms of degree of fluctuation or volatility
how does standard deviation relate to level of risk?
low=low risk
high= high risk (greater volatility)
what is a benchmark in investing?
simply a standard against which it is reasonable to compare the performance of a share or fund
what is a typical funds benchmark?
- performance of peer funds to which it belongs
- relevant market index
- return on a particular government bond or risk free asset
what do different beta factors convey?
- beta factor of one= moves in line with benchmark
- beta factor greater than one= varies more widely than the market or benchmark
- beta factor less than one= fluctuates less than the wider benchmark
how are beta values calculated
over a 36 month period, calculated from historical data
what is the alpha measurement?
difference between the funds expected returns (beta) and its actual returns
what is the disadvantage of using the alpha measurement?
does not distinguish between underperformance caused by incompetence and underperformance caused by fees (expenses added on top)
what is the sharpe ratio?
measures the excess return of a portfolio over the risk free interest rate (rate that is assumed can be can be obtained by investing in financial instruments with no default risk)
how is the sharpe ratio calculated?
sharpe ratio= return on the portfolio - risk free return/ standard deviation of portfolio
what is the relationship between the sharpe ratio and the risk adjusted performance of the portfolio?
higher the sharpe ratio, better the risk-adjusted performance of the portfolio and greater 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 (standard deviation of returns relative to the benchmark, similar to beta)
how is the information ratio calculated?
information ratio= mean of excess returns/ standardised deviation of excess return from the benchmark
what is private equity?
illiquid asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange, involve either an injection of capital into or the acquisition of an operating company
what are the risks of private equity?
risk of losing the initial investment if the firm fails, lack of stock market listing means lack of transparency in the firms operations and finances
what is venture capital?
type of private equity capital, typically provided to early stage, high potential growth companies in the hope of generating a return through an eventual sale once it has become succesful
how is venture capital illiquid?
entrepreneurial idea that is being funded by the venture capital may require several years to come to fruition, until that point there is no market for the firms shares
what is the risk related to venture capital?
risk that the initial idea being funded is never able to be brought to market in which case there is no return on the investment
what is asset allocation in correlation of performance between asset classes?
macro equivalent of diversifying a portfolio to reduce its risk, involves considering the big picture first by assessing prospects for each of the main asset classes within each of the world’s major investment
what is an investment mandate?
determines the funds aims, limits within which it is supposed to invest and the investment policy it should follow
what does the mandate typically define?
maximum tracking error, investment restrictions placed on the fund
how is it ensured that mandate limits aren’t breached?
limits will be transformed into more stringent limits against which the fund is managed, need to prevent the wording from being too specific or they run the risk of being sued if performance deteriorates
how can a properly constructed portfolio display risk?
can display much lower risk characteristics than the average of the risks of its individual assets
what is optimisation?
portfolio construction techniques that obtain the best expected returns from the right mix of correlations and variances (mean-variance optimisation)
what is diversification?
when an investor reduces market risk simply by investing in many unrelated instruments. risk reduction is free because expected returns are not affected
what is hedging?
means of reducing the risk of adverse price movements by taking an offsetting position in related products, management of offsetting risks
what is short selling?
selling a security which an investor doesn’t own in anticipation of its price reducing so that I can be bought back for less than it was sold for, method of reducing portfolio risk in falling markets
what is risk transfer?
when a portfolio manager chooses to buy or sell protection on fixed income assets whose credit rating they believe are management
what are the main areas where a portfolio will benefit from monitoring, management and reporting?
peer review, risk review, monitoring for mandate compliance, performance attribution reporting
