Chapter 6 - Nature And Impact Of The Main Types Of Risk On Investment Performance

Question 1

Is inflation usually a major consideration for short-term investment?

Answer 1

No, maximising nominal returns with investment safety is usually more important, although inflation could be a major issue in periods of high inflation. In periods of low inflation is more of an issue for long-term investments.

Question 2

What are the main risks that an investor should be aware of when investing in a UK corporate bond?

Answer 2

Interest rate risk, credit risk and inflation risk are the main risks event risk and liquidity risk should also be considered.

Question 3

Explain the five different types of credit risk.

Answer 3

The five different types of credit risk are:

1. default risk - the risk of the issue of defaulting on an interest payments or the repayment of capital
2. downgrade risk - the risk of bonds being downgraded by a rating agency or of an anticipated downgrade.
3. credit spread risk – a widening of credit spreads will lead to corporate bonds underperforming gilts.
4. counterparty risk - the risk of a counter party not paying what is obliged to pay on a security or other transaction.
5. bail-in risk - the risk of financial assistance coming from existing capital base, I thought he got the institutions shareholders, bondholders and depositors, not a government or central bank.

Question 4

If investor borrows 25% of the cost of investment, how much do they lose, in percentage terms, if the value of the investment falls by 10%?

Answer 4

If the investment cost £100,000, say, they borrow 25%, which is £25,000, then the outlay is £75,000

If the investment falls by 10% or £10,000, then this is 13.33% of £75,000. They have lost 13.33% of the original investment

Question 5

What is systematic and what is non-systematic risk

Answer 5

Systematic is when it effects the whole market (Or whole system)

Non-systematic is when it is business specific - This risk can be reduced using diversification

Question 6

What are the measures of inflation

Answer 6

Consumer price index-this is the main measure of inflation is by the government target of 2%, it is used for increasing benefits and a state pension

Consumer price housing index- this is more comprehensive than the CPI, As it includes the cost of owning maintaining and living in your own home which is not accounted for in CPI, however other than this CPIH is identical to CPI

Retail price index-this used to be the main measure of UK inflation, however, is not anymore. It is still used for contracts such as pension increases and currently for index linked gilts

Question 7

What is real asset protection

Answer 7

This is where investments in real assets protect against inflation as they generally move in line with the rises and falls of inflation

Question 8

Causes of inflation and what this can lead to

Answer 8

It has been blamed on rising demand fuelled by expanding money supply

This then causes the following

Bottlenecks in production as prices rise and imports flowed into the economy
Governments and financial markets respond with rising interest rates leading to cuts in public expenditure as well as tax increases
The economy enters recession and prices steady or fall off a supply of goods and services exceeds academic demand

Question 9

The difference between inflation, deflation and stagflation

Answer 9

Inflation is the rise of prices, deflation is the reverse,

stagflation is a combination of stagnant growth and inflation, This is a sign of weak business performance and usually rising unemployment causing a very fragile economy

Question 10

What investments might an investor consider including in their portfolio to give some protection against inflation

Answer 10

Real assets as these generally move in line with the rates of inflation

Question 11

Causes of interest rate moves

Answer 11

Economic cycle-strong demand reflecting strong economic activity will push up rates whereas rates will be lower in a recession.

Government fiscal policy – when government plans to issue gilts to fund a deficit, this will tend to push up to the medium and long-term guilt yields.

Government monetary policy – quantitive easing tends to reduce short-term rates, when the government is also purchasing long dated bonds, this will also impact on long-term rates.

Inflation expectations – if inflation is expected to increase, this will push up long-term interest rates, typically leading to a steeper yield curve.

Preference for liquid securities – in terms of uncertainty, investors prefer to hold their money in short-term securities, pushing down short-term rates.

Question 12

List six major risks that affect investments, other than inflation risk

Answer 12

Currency risk, liquidity risk, event risk, political risk, operational risk, credit risk.

Question 13

What is diversification, and how can it be done

Answer 13

Diversification refers to combining investments in a way that reduces the overall risk of a portfolio.

Diversification can be carried out at a site class or geographical level or by holding a diversified portfolio of securities within a single market

Question 14

The effects of gearing

Answer 14

Giving increases risk by magnifying glasses or gains made in a portfolio when the underlying security price moves

Question 15

What is denoted by Beta (b)

Answer 15

The measure of market risk also know as systematic risk