Chapter 6 - Risk and Return

Question 1

what do rational investors require?

Answer 1

require the highest possible return and the lowest possible risk exposure

Question 2

the relationship between risk and return

Answer 2

positive

The higher the expected return the higher the risk of exposure

Question 3

What does return on an investment represent?

Answer 3

The expected benefits that will be earned

Question 4

Determine the return

Answer 4

determine the profit

calculate the rate of return

Question 5

The rate of return formula

Answer 5

expected price @ year end - current price / current price x 100

Question 6

single period return

Answer 6

keep investment for a certain period of time ( 1 year)

two forms of return for stock investment: dividend or captial profit/loss

Question 7

single period return formula

Answer 7

capital P/L + dividends / initial price x 100

Question 8

What are the advantages of single period return?

Answer 8

Simple to calculate

simplifies the comparison between different investments

Question 9

what are the disadvantages of the single period return

Answer 9

method does not take the time value of money into consideration

Question 10

What is the internal rate of return?

Answer 10

an investment held for a longer period of time and a series of dividend payments is received.
(discount rate- if the present value of all future receipts is calculated by using IRR = present price of share.

Question 11

Advantages of using internal rate of return

Answer 11

the time value of money is take into consideration

makes provision for more than one period

Question 12

disadvantages of the internal rate of return

Answer 12

expected future values are required

large degree of uncertainty regarding future dividend income and the selling prices

Question 13

What is risk

Answer 13

• Probability that the actual performance may differ from the expected return
• investor will be negatively influenced
• unexpected deviation from the expected return

Question 14

systematic risk

Answer 14

occurrences in financial markets

• all the risks that are the result of changes in the total economy
• influence all enterprises and investments

Question 15

Types of systematic risk

Answer 15

interest rate risk 
cyclical risk 
inflation risk 
exchange rate risk 
market risk

Question 16

Interest rate risk

Answer 16

The probability that the change in interest rates will have a negative effect on the return of an investment.
Inverse relationship

Question 17

How does the negative effect of the interest rate impact share prices

Answer 17

difference exists between the risk of exposure and fixed deposit. investors decide to invest their funds in the fixed deposit (safer) if the return is high enough. (d decreases and SP drop).

increase in interest rate = higher FC that use DC to finance their investments. if return is not high enough to make up the increate in ir they will sell their shares = decrease SP

Question 18

Methods that decrease interest rate risk

Answer 18

1) Buy securities with short remaining term
2) Hold fixed income securities until maturity date
3) Conducting a thorough analysis of variables that influence interest rate decisions, such as the variables considered by monetary authorities

Question 19

What is cyclical risk

Answer 19

The probability that share prices will be negatively influenced by changes in the economic cycle

Question 20

Methods to reduce cyclical risk

Answer 20

diversification over time
diversification between different types of investments
timing

Question 21

inflation risk

Answer 21

The value of money decreases constantly as a result of inflation - negative impact on returns

Question 22

Real rate of returns

Answer 22

(1+ nominal return / 1 + inflation rate ) - 1 x 100

Question 23

How do I hedge against inflation risk

Answer 23

• internal diversification
• balanced diversified portfolio
• timing
• inflation linked securities

Question 24

What is exchange rate risk

Answer 24

The uncertainty regarding returns for the investor that are exposed to foreign securities

• the more volatile the exchange rate between 2 countries the higher the exchange rate risk

Question 25

How can investors protect themselves from exchange rate risk

Answer 25

exchange rate cover thorough analysis of the company internal diversification

Question 26

What is market risk

Answer 26

The probability that the mp of an investment will differ from its intrinsic value due to irrational investor behaviour. Mp> intrinsic overvalued Mp< intrinsic undervalued

Question 27

What must investors consider in order to protect themselves from market risk

Answer 27

timing longer investment term international diversification through analysis of the share

Question 28

Non- systematic return

Answer 28

actions of the enterprise itself - enterprise influences the extent of the risks

Question 29

Types of non systematic risk

Answer 29

operating risk financial risk industry risk other risk factors

Question 30

What is operating risk

Answer 30

operating profit is influenced by the nature of the the enterprises activities and the effect of operating gearing. Effect of changing market conditions on operating profit An enterprise with a large component of fixed costs in its costs structure Highest for enterprises with: Unsteady revenue streams Large % of fixed costs in the cost structure

Question 31

what is financial risk

Answer 31

The way in which an enterprises is financed influences its exposure to financial risk. measured by means of financial gearing. If an enterprise includes debt capital in its capital it can lead to increased instability of the return of equity and the EPS.

Question 32

Negative and positive financial leverage

Answer 32

positive : cost < return on assets - cost of debt capital is lower than return on total assets negative: cost>return on assets - cost of debt capital higher than return on total assets

Question 33

methods to decrease exposure to financial risk

Answer 33

Analysis of an enterprises capital structure | market interest rates

Question 34

what is Industry risk

Answer 34

some risks are limited to specific industries. only enterprises active in these industries are influenced by these risks. Different factors that might give rise to this risk. For example, dependence on specific raw material, high labour intensity, capital intensity, technological changes

Question 35

Hedging against industry risk

Answer 35

Thoroughly informed about situations that may occur within a specific industry Thorough investigation of the branch of industry

Question 36

Other risk factors for non systematic risk include

Answer 36

``` Bad inventory control Changes in top management Legal actions taken against the enterprise Weak liquidity New competitors Outdated technology ```

Question 37

what is Quantification of risk

Answer 37

A positive relationship usually exits between the risk of an investment and the reign required by investors.

Question 38

what do Rational investors require

Answer 38

a certain minimum return on any investment. return will be more or less equal to the return that can be earned (risk- free investment) if slightly more risky then risk free investment requires a risk premium to reward them for the additional risk exposure. (size depends on investor

Question 39

Risk adverse investors vs risky investors

Answer 39

risk adverse require relatively large risk premiums while more risky investors require a smaller premium.

Question 40

The beta- analysis

Answer 40

Beta-indicates how sensitive a share’s price is relative to the price of other shares in the specific market (risk measure) Determines how a share’s price will react to changes in a specific sector or the market as a whole

Question 41

The system developed to measure the beta system

Answer 41

the Barra system β > 1: Share is more sensitive than the market β < 1: Share is less sensitive than the market β = 1: Share prices move with the market

Question 42

Which shares will be included with certain beta portfolios

Answer 42

The type of share and the specific beta that is preferred depends on the economic cycle Bull market – high beta Bear market – low beta An investor will consider a number of factors before an investment decision is made, for example: Beta in combination with market value and intrinsic value