Chapter 6: Investment Risk

Question 1

what is nominal returns?

Answer 1

returns unadjusted for inflation

Question 2

what are real returns?

Answer 2

return an investment provides after stripping the effects of inflation

Question 3

how is the real rate of return calculated?

Answer 3

(1+real rate of return) = 1+nominal rate of return/(1+inflation rate)

Question 4

what are total returns?

Answer 4

returns on investment from both income productions (dividends) and any capital gain

Question 5

what is the holding rate of return?

Answer 5

return on an asset or portfolio over the period with which it was held

Question 6

how do rates of return on asset classes vary?

Answer 6

volatility for equities is usually much higher than fixed income securities, longer the available time the more can be invested into equities

Question 7

what is currency risk?

Answer 7

risk arising from fluctuations in the value of currencies against one another

Question 8

what is interest rate risk?

Answer 8

risk that interest rates move against one another, can also affect investors capital in terms of fixed income securities

Question 9

what is issuer risk?

Answer 9

risk that the bond issuer gets into financial difficulties and cannot keep up interest payments or defaults on the final repayment

Question 10

what risk factors affect the riskiness of investment in shares?

Answer 10

• liquidity, growth, volatility, strategic risk of the institution

Question 11

what is growth risk?

Answer 11

whether the investors shares rise in price and will the company make enough profits to pay steady and rising dividends

Question 12

what is the reward that can be gained from taking on growth risk?

Answer 12

if the company does very well, investors may make large capital gains with no ‘cap’ on how high these could be

Question 13

what strategic risks are companies subject to?

Answer 13

• industry and cyclicality
• competence of management
• financial soundness of the company

Question 14

what are the distinguishing features of property?

Answer 14

• subjective nature of valuation
• high up front costs
• complex legal considerations

Question 15

what risks are associated with property?

Answer 15

location, use of the property on its value, credit quality, length of the lease

Question 16

what market factors affect property risk?

Answer 16

changing interest rates, performance of individual property sectors, prospects for rental income growth

Question 17

what is liquidity risk concerned with?

Answer 17

ease with which investment assets can be: sold for cash, used as collateral to secure cash flows

Question 18

how is investment risk usually measured?

Answer 18

measured in terms of degree of fluctuation or volatility

Question 19

how does standard deviation relate to level of risk?

Answer 19

low=low risk
high= high risk (greater volatility)

Question 20

what is a benchmark in investing?

Answer 20

simply a standard against which it is reasonable to compare the performance of a share or fund

Question 21

what is a typical funds benchmark?

Answer 21

• performance of peer funds to which it belongs
• relevant market index
• return on a particular government bond or risk free asset

Question 22

what do different beta factors convey?

Answer 22

• 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

Question 23

how are beta values calculated

Answer 23

over a 36 month period, calculated from historical data

Question 24

what is the alpha measurement?

Answer 24

difference between the funds expected returns (beta) and its actual returns

Question 25

what is the disadvantage of using the alpha measurement?

Answer 25

does not distinguish between underperformance caused by incompetence and underperformance caused by fees (expenses added on top)

Question 26

what is the sharpe ratio?

Answer 26

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)

Question 27

how is the sharpe ratio calculated?

Answer 27

sharpe ratio= return on the portfolio - risk free return/ standard deviation of portfolio

Question 28

what is the relationship between the sharpe ratio and the risk adjusted performance of the portfolio?

Answer 28

higher the sharpe ratio, better the risk-adjusted performance of the portfolio and greater level of active management skill

Question 29

what is the information ratio?

Answer 29

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)

Question 30

how is the information ratio calculated?

Answer 30

information ratio= mean of excess returns/ standardised deviation of excess return from the benchmark

Question 31

what is private equity?

Answer 31

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

Question 32

what are the risks of private equity?

Answer 32

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

Question 33

what is venture capital?

Answer 33

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

Question 34

how is venture capital illiquid?

Answer 34

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

Question 35

what is the risk related to venture capital?

Answer 35

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

Question 36

what is asset allocation in correlation of performance between asset classes?

Answer 36

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

Question 37

what is an investment mandate?

Answer 37

determines the funds aims, limits within which it is supposed to invest and the investment policy it should follow

Question 38

what does the mandate typically define?

Answer 38

maximum tracking error, investment restrictions placed on the fund

Question 39

how is it ensured that mandate limits aren’t breached?

Answer 39

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

Question 40

how can a properly constructed portfolio display risk?

Answer 40

can display much lower risk characteristics than the average of the risks of its individual assets

Question 41

what is optimisation?

Answer 41

portfolio construction techniques that obtain the best expected returns from the right mix of correlations and variances (mean-variance optimisation)

Question 42

what is diversification?

Answer 42

when an investor reduces market risk simply by investing in many unrelated instruments. risk reduction is free because expected returns are not affected

Question 43

what is hedging?

Answer 43

means of reducing the risk of adverse price movements by taking an offsetting position in related products, management of offsetting risks

Question 44

what is short selling?

Answer 44

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

Question 45

what is risk transfer?

Answer 45

when a portfolio manager chooses to buy or sell protection on fixed income assets whose credit rating they believe are management

Question 46

what are the main areas where a portfolio will benefit from monitoring, management and reporting?

Answer 46

peer review, risk review, monitoring for mandate compliance, performance attribution reporting