Chapter 9: Investment Management

Question 1

How is expected return calculated?

Answer 1

Probability * Scenario Return
P x SR

Question 2

What is Market/Systematic risk?

Answer 2

The risk that the overall market will rise or fall due to market factors

Question 3

What is inflation risk?

Answer 3

The risk that inflation may be different to expected, thus affecting expected return

Question 4

Which market is mostly affected by inflation?

Answer 4

Fixed-income

Question 5

Why is inflation mitigated in equity markets?

Answer 5

Companies can pass on higher costs to customers

Question 6

What is interest rate risk?

Answer 6

Changes in interest rate, that will affect company financing

Question 7

What is reinvestment risk?

Answer 7

Where an investor cannot invest maturing assets at the same rate as originally obtained

Question 8

What is exchange rate risk?

Answer 8

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

Question 9

What is political and legal risk?

Answer 9

Policy and law changing that causes the value of an investment to decline
Tax
Sanctions
War
Capital controls

Question 10

What is regulatory risk?

Answer 10

Change in regulations/legislation will affect a security, company or industry.

Question 11

What is default risk?

Answer 11

Issuer from where investor purchased security becomes insolvent

Question 12

What is liquidity risk?

Answer 12

Investor may not be able to obtain the price they want for a security

Question 13

What are the two ways to quantify risk?

Answer 13

Forwards and backwards looking

Question 14

What other benefit apart from ownership & dividends do shareholders get

Answer 14

Limited liability. The maximum loss is what they paid for the shares.

Question 15

What is equity risk premium?

Answer 15

The return over the risk-free rate when invested in equities

Question 16

What are money markets?

Answer 16

Short term investment (6-months) for cash, usually gov bonds

Question 17

What is the desire to move to short term paper in times of crisis called?

Answer 17

Flight to safety

Question 18

What does SOFR stand for?

Answer 18

Secured Overnight Financing Rate

Question 19

What is the Secured Overnight Financing Rate?

Answer 19

The cost of borrowing cash overnight, collateralized by US Treasury Bonds

Question 20

What is the primary financing rate in sterling markets?

Answer 20

SONIA

Question 21

What does SONIA stand for?

Answer 21

Sterling Overnight Index Average

Question 22

What are the two investment grades of bonds?

Answer 22

Investment grade
Sub-investment grade

Question 23

Why might an emerging market issuer use credit enhancement on debt?

Answer 23

Increase rating, to make it more marketable to investors

Question 24

What is specific/unsystematic risk?

Answer 24

Risk that impacts a particular investment, such as a poor business decision

Question 25

How can you reduce specific risk?

Answer 25

Diversification

Question 26

How do assets need to be correlated to achieve diversification?

Answer 26

Uncorrelated

Question 27

What risk cannot be diversified away?

Answer 27

Market risk

Question 28

What is diversification by maturity?

Answer 28

Investing in fixed income securities with different redemption dates.

Question 29

What risk does diversification by maturity mitigate?

Answer 29

Reinvestment risk, can spread out reinvestment across a larger time period

Question 30

What is diversification by maturity also known as?

Answer 30

Laddering

Question 31

What is the objective of hedging?

Answer 31

Buy or sell derivatives that reduce the exposure to market fluctuations

Question 32

What has to be taken into account when hedging equities with futures?

Answer 32

Beta relative to the index which the futures contract represents
e.g. beta of 1.2 will mean you have to purchase 20% more

Question 33

What are the shortcomings of hedging with futures contracts? (3)

Answer 33

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

Question 34

How can a portfolio be hedged with options?

Answer 34

Purchasing options on the individual securities or a similar index

Question 35

How do CFDs differ from other derivatives?

Answer 35

The holder does not take ownership of the underlying asset

Question 36

Why would a manager choose CFDs over options/futures?

Answer 36

They are highly leveraged leaving them with more cash for other trades

Question 37

What charge are CFDs subject to?

Answer 37

Daily financing charge, usually at a rate like SOFR

Question 38

What is initial margin in CFD?

Answer 38

The amount that you will have to post up when entering a CFD
5-30% for stocks
1% for indices/forex

Question 39

What is the seniority of shareholders in liquidation?

Answer 39

Preference shareholders will be paid back par value of shares before any distribution to ordinary.

Question 40

What is liquidation preference?

Answer 40

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

Question 41

What are the 3 levels of debt seniority?

Answer 41

Senior
Subordinated
Mezzanine / PIK (Payment in Kind)

Question 42

What are PIK notes?

Answer 42

Bonds that have a quoted coupon rate but it is only paid at maturity

Question 43

What are DB and DC pension schemes?

Answer 43

DB - Defined Benefit: Set salary
DC - Defined Contribution: Based on investments

Question 44

What is a term assurance policy?

Answer 44

Pay out if individual dies before set policy term

Question 45

What is a whole of life policy?

Answer 45

Pay out on death

Question 46

What is an endowment policy?

Answer 46

Term assurance policy with an investment element