Chapter 6 - investment risk Flashcards

1
Q

What is the nominal return

what is the real rate of return

what is the total return

what is holding period returns

A

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

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
2
Q

Formula for compounding interest

how can interest be collected?

A

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

daily,weekly,monthly,yearly, quarterly

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
3
Q

what does the term present value mean?

A

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.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
4
Q

understand how the rates of return from the main asset classes vary?

A

S&P 500 = 7.8%
Corporate bonds = 6.1%
Treasury bonds = 1.6%

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
5
Q

Understand the main investment risks and implications: Currency risk

A

Risk arising from fluctuations in value of currencies.

Fluctuates because:
- the changing dollar share price
- changing US dollar / Yuan exchange rate

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
6
Q

Understand the main investment risks and implications: Interest rate risk

A

risk that interest rates move against the investor.

This affects investors capital, for example fixed-income securities because they will move in opposite directions

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
7
Q

Understand the main investment risks and implications: Issuer risk

A

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.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
8
Q

Certain specific factors that affect the riskiness of investment in shares:

A
  • liquidity risk
  • growth risk
  • volatility risk
  • strategic risk of issuing institution
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
9
Q

what are the different strategic risks which are determined by?

A
  • nature of industry and its cyclicality
  • Competence of management
  • financial soundness
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
10
Q

commodity risk

A

WWM = gold bullion for pure gold

Commodities are volatile which links to natural events, such as harvests.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
11
Q

what is liquidity risk concerned with?

what is investment liquidity risk?

A
  • 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 well did you know this?
1
Not at all
2
3
4
5
Perfectly
12
Q

6.2.2 how can an asset and portfolio investment be calculated?

A

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 and low risk
  • an investment with high returns and does vary from average = high SD and high risk
How well did you know this?
1
Not at all
2
3
4
5
Perfectly
13
Q

How can volatility in the value of an investment be quantified mathematically?

A

calculating the standard deviation of the values. the more volatile, the higher the standard deviation.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
14
Q

what does standard deviation show?

A

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.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
15
Q

6.2.3 what should a benchmark be?

A

relevant to the market and used consistently. the manager should not switch benchmarks simply to show the fund’s performance in a better light.

How well did you know this?
1
Not at all
2
3
4
5
Perfectly
16
Q

what does beta measure?

what does a high value suggest?

Beta value of 1, greater than 1, less than 1

A

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.

17
Q

how are beta funds calculated?

A

Over a 36-month period, calculated using historical data, any changes may mean the future performance differs from the past.

18
Q

what is alpha?

what is disadvantage?

what should index funds have? however…

A

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.

19
Q

what is the sharpe ratio?

what does the risk-free return rate assume?

what does it use instetad?

however?

formula?

A

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.

it uses a truly risk free security, such as a short-dated government bond or relevant currency.
However, financial instrument can carry other risks.

Formula =
Return on portfolio - risk free return / Standard deviation of portfolio

20
Q

the higher the Sharpe ratio?

A

Higher ratio = the better the risk-adjusted performance of the portfolio and the greater the implied level of active management skill.

21
Q

what is the information ratio

what is the tracking error

what is the formula

why would a funds performance deviate from the benchmark?

A

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

22
Q

6.2.4 what is venture capital

three advantages

A

type of private equity, provided to early-stage, high potential growth companies in the hope of generating a return through eventual sale of company.

typically made in cash

Three advantages
- tax advs, higher returns, lack of correlation with standard investments.

23
Q

what is private equity?

A

illiquid asset class that consists of equity securities in operating companies that are not publicly traded on stock exchange.

24
Q

responsible investments

who argues its good for investing.

A

links to ESG.

Moringstar, fund rating agency stages ESG “bedrock of investing”

25
what are the social concerns and corporate governance concerns
social - human rights and animal welfare, consumer protection corporate governance - roles and responsibilities, management structure, employee stuff
26
6.2.5 what is asset allocation
considering big picture by assessing prospects for each other the main asset classes within each investment region.
27
6.2.6 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" Historical is calculated by using the standard deviation of returns relative to the benchmark and is more useful for reporting performance Predictive tracking error =for simple equity models, it is called ex ante, it uses beta as a primary determinant to more complicated multi-factor fixed income models. this is used by portfolio managers to control risk.
28
6.2.8 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)
29
6.2.7 what does an investment mandate include? problems that could occur how to reduce breaches
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 breaches reduced - mandate limits will be transformed into more stringent internal limits against which the fund is managed
30
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
31
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
32
what does a robust risk management process ensure?
key to ensuring an appropriate balance between risk and return
33
what task does the investment management committee do
challenge the investment managers and ensure the appropriate monitoring takes place.
34
6.2.9 what are the four areas a portfolio will benefit from monitoring, management, and reporting
- peer review with other fund managers in the same firm (help ensure no unusual risk are taken and abiding to house view rules) - risk review with independent risk managers in the firm (ensures transparency and challenged) - monitoring for mandate compliance - performance attribution reporting
35
what does the firm-specific client and internal reporting requirements determined?
the extent to which the results of the above monitor and management process will be more widely shared.
36
in context of investment risk, what does standard deviation measure?
The volatility of an investment
37
what does low standard deviation suggest? and high?
low = less risk high = more risk
38
which fund would have the lowest tracking error? why?
FTSE all-fund index Index funds should have minimal tracking error
39
what does a peer review help?
Peer review with other fund managers helps make investment decisions which are outside of firm.