Chapter 9: Investment Management Flashcards
How is expected return calculated?
Probability * Scenario Return
P x SR
What is Market/Systematic risk?
The risk that the overall market will rise or fall due to market factors
What is inflation risk?
The risk that inflation may be different to expected, thus affecting expected return
Which market is mostly affected by inflation?
Fixed-income
Why is inflation mitigated in equity markets?
Companies can pass on higher costs to customers
What is interest rate risk?
Changes in interest rate, that will affect company financing
What is reinvestment risk?
Where an investor cannot invest maturing assets at the same rate as originally obtained
What is exchange rate risk?
Where an investor who invests in securities denominated in a foreign currency can suffer from adverse moves in the price relative to their home currency
What is political and legal risk?
Policy and law changing that causes the value of an investment to decline
Tax
Sanctions
War
Capital controls
What is regulatory risk?
Change in regulations/legislation will affect a security, company or industry.
What is default risk?
Issuer from where investor purchased security becomes insolvent
What is liquidity risk?
Investor may not be able to obtain the price they want for a security
What are the two ways to quantify risk?
Forwards and backwards looking
What other benefit apart from ownership & dividends do shareholders get
Limited liability. The maximum loss is what they paid for the shares.
What is equity risk premium?
The return over the risk-free rate when invested in equities
What are money markets?
Short term investment (6-months) for cash, usually gov bonds
What is the desire to move to short term paper in times of crisis called?
Flight to safety
What does SOFR stand for?
Secured Overnight Financing Rate
What is the Secured Overnight Financing Rate?
The cost of borrowing cash overnight, collateralized by US Treasury Bonds
What is the primary financing rate in sterling markets?
SONIA
What does SONIA stand for?
Sterling Overnight Index Average
What are the two investment grades of bonds?
Investment grade
Sub-investment grade
Why might an emerging market issuer use credit enhancement on debt?
Increase rating, to make it more marketable to investors
What is specific/unsystematic risk?
Risk that impacts a particular investment, such as a poor business decision
How can you reduce specific risk?
Diversification
How do assets need to be correlated to achieve diversification?
Uncorrelated
What risk cannot be diversified away?
Market risk
What is diversification by maturity?
Investing in fixed income securities with different redemption dates.
What risk does diversification by maturity mitigate?
Reinvestment risk, can spread out reinvestment across a larger time period
What is diversification by maturity also known as?
Laddering
What is the objective of hedging?
Buy or sell derivatives that reduce the exposure to market fluctuations
What has to be taken into account when hedging equities with futures?
Beta relative to the index which the futures contract represents
e.g. beta of 1.2 will mean you have to purchase 20% more
What are the shortcomings of hedging with futures contracts? (3)
The beta (risk characteristics) of the portfolio may not be emulated by any index with futures available. E.g. emerging markets
Timing, hedging reduces upside
Operational and regulatory considerations
How can a portfolio be hedged with options?
Purchasing options on the individual securities or a similar index
How do CFDs differ from other derivatives?
The holder does not take ownership of the underlying asset
Why would a manager choose CFDs over options/futures?
They are highly leveraged leaving them with more cash for other trades
What charge are CFDs subject to?
Daily financing charge, usually at a rate like SOFR
What is initial margin in CFD?
The amount that you will have to post up when entering a CFD
5-30% for stocks
1% for indices/forex
What is the seniority of shareholders in liquidation?
Preference shareholders will be paid back par value of shares before any distribution to ordinary.
What is liquidation preference?
Usually a multiple of the original purchase price of the shares that is paid to preference shareholders e.g. 2x
Paid to VC / angel investors
What are the 3 levels of debt seniority?
Senior
Subordinated
Mezzanine / PIK (Payment in Kind)
What are PIK notes?
Bonds that have a quoted coupon rate but it is only paid at maturity
What are DB and DC pension schemes?
DB - Defined Benefit: Set salary
DC - Defined Contribution: Based on investments
What is a term assurance policy?
Pay out if individual dies before set policy term
What is a whole of life policy?
Pay out on death
What is an endowment policy?
Term assurance policy with an investment element