Chapter 6 - investment risk Flashcards
What is the nominal return
what is the real rate of return
what is the total return
what is holding period returns
The return an investment gives, unadjusted for inflation
Real return = return an investment provides after effects of inflation.
(1 + real rate of return) x (1 + inflation rate) = 1 + nominal rate of return
Total return = returns on investment from both income production and any capital gains or losses its generated.
Holding period returns = percentage by which the value of a portfolio has grown for a particular period. sum of income and capital gains / initial period value
Formula for compounding interest
s = X (1+r)n
X = original sum invested
R = Interest rate
N = number of periods over which were compounding
S = Sum invested after n periods
what does the term present value mean?
refers to amount of money which must be invested now for n years at an interest rate or x to earn a given future sum of money at the time it will be required.
Understand the main investment risks and implications: Currency risk
Risk arising from fluctuations in value of currencies.
Fluctuates because:
- the changing dollar share price
- changing US dollar / Yuan exchange rate
Understand the main investment risks and implications: Interest rate risk
risk that interest rates move against the investor.
This affects investors capital, for example fixed-income securities because they will move in opposite directions
Understand the main investment risks and implications: Issuer risk
Risk that the bond issuer, gets into financial troubles and cannot keep up with the interest payments, or defaults on final repayment.
Government bonds = less risky
Sovereign risk = risk isn’t fully gone and is there time to time.
Certain specific factors that affect the riskiness of investment in shares:
- liquidity risk
- growth risk
- volatility risk
- strategic risk of issuing institution
what are the different strategic risks which are determined by?
- nature of industry and its cyclicality
- Competence of management
- financial soundness
commodity risk
WWM = gold bullion for pure gold
Commodities are volatile which links to natural events, such as harvests.
what is liquidity risk concerned with?
what is investment liquidity risk?
- sold for cash = investors may need to accept lower price than anticipated if need for cash is urgent
- used as collateral against which to secure increased cash inflows - if bad credit history, more collateral needed.
investment liquidity risk
- refers to likelihood of being unable to transform assets into cash within a preferred time, closely linked to credit and market risk.
how can an asset and portfolio investment be calculated?
Standard Deviation (how widely the value of an investment fluctuates around the average).
- an investment with low returns and doesn’t vary from average = low deviation.
what does standard deviation show?
The range of different values of return
Two-thirds of the time, we can expect the return to be within one standard deviation above or below average.
what should a benchmark be?
relevant to the market and used consistently. the manager should not switch benchmarks simply to show the fund’s performance in a better light.
what does beta measure?
what does a high value suggest?
Beta value of 1, greater than 1, less than 1
measures the volatility of an investment relative to the market or benchmark.
Higher value = greater movement in its return relative to the market or benchmark.
Beta factor of one = moves in line, index funds should have a beta factor that is equal to or close to one.
Beta factor greater than one = wider than the market or the benchmark.
Beta factor less than one = fluctuates less than the wider market or benchmark.
how are beta funds calculated?
Over a 36-month period, calculated using historical data, any changes may mean the future performance differs from the past.
what is alpha?
what is disadvantage?
what should index funds have? however…
the extent to any outperformances against its benchmark, difference between funds expected returns and actual returns.
Disadvantage
- does not distinguish between underperformance caused by incompetence and underperformance caused by fees
Index funds should have alpha of zero, however many have negative alphas because of fund expenses.
what is the sharpe ratio?
what does the risk-free return rate assume?
however?
formula?
measures the return of portfolio over risk-free interest rate (financial instrument with no default risk)
Risk-free return rate is the rate that is assumed can be obtained by investing in financial instruments with no default risk.
However, financial instrument can carry other risks.
Formula =
Return on portfolio - risk free return / Standard deviation of portfolio
the higher the Sharpe ratio?
Higher ratio = the better the risk-adjusted performance of the portfolio and the greater the implied level of active management skill.
what is the information ratio
what is the tracking error
what is the formula
why would a funds performance deviate from the benchmark?
Compares the excess return achieved by a fund over its benchmark, to the funds tracking error.
Tracking error = standard deviation of returns relative to the benchmark. It is a measure of how closely a portfolio follows the index to which its benchmarked.
Formula = means of excess returns / standard deviation of excess returns from benchmark
Deviate because investment manager decision concerning asset weighting.
HIGH INFORMATION RATIO = Successful
what is venture capital
three advantages
type of private equity, provided to early-stage, high potential growth companies in the hope of generating a return through eventual sale of company.
Three advantages
- tax advs, higher returns, lack of correlation with standard investments.
what is private equity?
illiquid asset class that consists of equity securities in operating companies that are not publicly traded on stock exchange.
responsible investments
who argues its good for investing.
links to ESG.
Moringstar, fund rating agency stages ESG “bedrock of investing”
what is asset allocation
considering big picture by assessing prospects for each other the main asset classes within each investment region.
what is a tracking error
how is it calculated?
what is predictive tracking error?
measure of how closely a portfolio follows the index to which it is benchmarked. It is classed as “realised” or “ex post”
calculated as either - historical or predictive indicator, and uses the standard deviation of returns
Predictive tracking error = ex ante, it uses beta as a primary determinant to more complicated mulit-factor fixed income models.
what is referred to as systematic risk
what is referred to as non-systematic risk or specific risk
when a portfolio moves in line with markets or benchmark. (cant be diversified)
when a portfolio seeks to gain an advantage over a benchmark (can be diversified by buying 15-20 stocks with a low or negative correlation)
what does an investment mandate include?
problems that could occur
determines the funds aims, the limits within which it is supposed to invest, the investment policy it must follow.
- strategies
- regions/sectors
- securities
- short sell
- geared
- index fund aims to beat
Problems - cant be too specific or risk of sue
what is optimisation?
what is it also called?
what can it be used for?
refers to portfolio construction techniques that obtain the best expected returns from the right mix of correlation and variances.
Also called mean-variance
Can be used to:
- minimise the risk of given return
- maximise expected return for given risk
what is short selling
selling a security which you don’t own, in anticipating of its price reducing so you can buy it back for less than you sold it for.
A short position benefits from a decline in the securities price
what are the four areas a portfolio will benefit from monitoring, management, and reporting
- peer review with other fund managers in the same firm
- risk review with independent risk managers in the firm
- monitoring for mandate compliance
- performance attribution reporting
in context of investment risk, what does standard deviation measure?
The volatility of an investment
what does low standard deviation suggest? and high?
low = less risk high = more risk
which fund would have the lowest tracking error? why?
FTSE all-fund index
Index funds should have minimal tracking error
what does a peer review help?
Peer review with other fund managers helps make investment decisions which are outside of firm.
