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

Question 1

Inflation risk - rate calc’d how (price analysis), index-linked securities and protecting against inflation long term but in short term only guaranteed to protect if…, heavy demand and yields

Inflation - how caused (think previous chapter) and cycles exaggerated by (war, imported goods and overseas inflation, currency and wages)

Answer 1

Inflation rate clc’d each month by analysing in prices of over 700 good and services in UK.

Index-linked government securities can provide protection against inflation in long term but in short term value driven by sentiment and inflation proofing only guaranteed if bought at issue and held to maturity. Heavy demand can also lead to negative yields.

Inflation caused by rising demand fuelled by expanding money supply. Some cycles are exaggerated by external events such as;

• war or shortages
• prices of imported goods increase as overseas experience inflation
• currency devaluation
• high wage demands

Question 2

Deflation - what does it cause

Stagflation - combo of, sign of (2, think business) and cant be solved by and why

Answer 2

Prospect of falling prices stops people spending as may be cheaper later.

Stagflation - combo of stagnant growth and inflation

• sign of weak business performance and rising unemployment
• cannot be solved by rising interest rates as eco weak and business would suffer

Question 3

Interest rate risk - modified duration - measure of what

Causes of interest rate movements and effect on interest rates;

• eco cycle - think previous chapter
• fiscal - gilts affect on med-long term yields
• monetary - quan easing effect on ST rates and can impact LT when?
• inflation expectations - if increase than what effect on LT interest rates leading to what (yield curve)
• liquid securities - uncertainty causes? (Money, ST and effect on ST rates)

Answer 3

Modified duration - measure of sensitivity of bond to move in interest rates.

Causes of interest rate movements;

• eco cycle - demand will push up rates
• fiscal - when issuing gilts, pushes up med-long term gilt yields
• monetary - quantitative easing reduces short term rates and can impact LT rates if gov purchasing long term bonds.
• inflation expectations - if expected to increase, increases longer term interest rates leading to steeper yield curve.
• liquid securities - in uncertainty, investors hold money in short term instruments which pushes down short term rates.

Question 4

Credit Risk - Important for what (2)

• default risk
• downgrade risk - market anticipates what, when downgraded what happens to yield and why and price of bond?
• credit spread risk - if inv nervous what happens and yield better
• counterparty - risk they wont pay what and product with what CP is exposed to CP risk

Event risk - unable to pay why?
Political risk - straightforward (policies)

Answer 4

Credit risk important for bonds or deposits.

Default risk - self explanatory
Downgrade risk - market anticipates that credit rating agency will downgrade a bond. When downgraded, yield rises to compensate greater risk and price of bond will fall.

Credit spread risk - if nervous go to quality therefore gov bonds yield better than corporate.

Counterparty risk - counterparty wont pay their obligation re a bond, derivative, trade or other transaction. Any product with derivative counterparty is exposed to CP risk.

Event risk - unable to pay obligations due to major unexpected event such as corporate (takeover) or regulatory change.

Political risk - new gov may have different fiscal or monetary policies

Question 5

Bail-in risk - what is it (financial assistance), may be used when and money taken from where

Currency risk - risk that sterling may what against what

Operational risk - looks at risks from what and includes;
- CP, illegal, misleading, systems, trading, staff, regulators

Answer 5

Bail in is where financial assistance comes from existing capital base such as shareholders, bondholders and depositors. May be used in future crisis and is where money is taken from account.

Currency risk - risk that sterling may appreciate against overseas currency.

Operational risk - look at risks that arise from investment process and include;

• counterparty - may fail to settle (like previous card)
• fraud
• misrepresentation - misleading reports or valuations
• systems failing
• trading errors or unauthorised trading
• staff errors
• regulatory risk

Question 6

Gearing - what is it (borrowing and other assets) and magnifies what

Answer 6

Borrowing money with the objective of increasing exposure to other assets. It will magnify positive and negative portfolio returns.