Chapter 6 - Risk and Return Flashcards
what do rational investors require?
require the highest possible return and the lowest possible risk exposure
the relationship between risk and return
positive
The higher the expected return the higher the risk of exposure
What does return on an investment represent?
The expected benefits that will be earned
Determine the return
determine the profit
calculate the rate of return
The rate of return formula
expected price @ year end - current price / current price x 100
single period return
keep investment for a certain period of time ( 1 year)
two forms of return for stock investment: dividend or captial profit/loss
single period return formula
capital P/L + dividends / initial price x 100
What are the advantages of single period return?
Simple to calculate
simplifies the comparison between different investments
what are the disadvantages of the single period return
method does not take the time value of money into consideration
What is the internal rate of return?
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.
Advantages of using internal rate of return
the time value of money is take into consideration
makes provision for more than one period
disadvantages of the internal rate of return
expected future values are required
large degree of uncertainty regarding future dividend income and the selling prices
What is risk
- Probability that the actual performance may differ from the expected return
- investor will be negatively influenced
- unexpected deviation from the expected return
systematic risk
occurrences in financial markets
- all the risks that are the result of changes in the total economy
- influence all enterprises and investments
Types of systematic risk
interest rate risk cyclical risk inflation risk exchange rate risk market risk
Interest rate risk
The probability that the change in interest rates will have a negative effect on the return of an investment.
Inverse relationship
How does the negative effect of the interest rate impact share prices
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
Methods that decrease interest rate risk
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
What is cyclical risk
The probability that share prices will be negatively influenced by changes in the economic cycle
Methods to reduce cyclical risk
diversification over time
diversification between different types of investments
timing
inflation risk
The value of money decreases constantly as a result of inflation - negative impact on returns
Real rate of returns
(1+ nominal return / 1 + inflation rate ) - 1 x 100
How do I hedge against inflation risk
- internal diversification
- balanced diversified portfolio
- timing
- inflation linked securities
What is exchange rate risk
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
How can investors protect themselves from exchange rate risk
exchange rate cover
thorough analysis of the company
internal diversification
What is market risk
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
What must investors consider in order to protect themselves from market risk
timing
longer investment term
international diversification
through analysis of the share
Non- systematic return
actions of the enterprise itself - enterprise influences the extent of the risks
Types of non systematic risk
operating risk
financial risk
industry risk
other risk factors
What is operating risk
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
what is financial risk
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.
Negative and positive financial leverage
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
methods to decrease exposure to financial risk
Analysis of an enterprises capital structure
market interest rates
what is Industry risk
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
Hedging against industry risk
Thoroughly informed about situations that may occur within a specific industry
Thorough investigation of the branch of industry
Other risk factors for non systematic risk include
Bad inventory control Changes in top management Legal actions taken against the enterprise Weak liquidity New competitors Outdated technology
what is Quantification of risk
A positive relationship usually exits between the risk of an investment and the reign required by investors.
what do Rational investors require
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
Risk adverse investors vs risky investors
risk adverse require relatively large risk premiums while more risky investors require a smaller premium.
The beta- analysis
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
The system developed to measure the beta system
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
Which shares will be included with certain beta portfolios
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
