Component 6: risk & return

Question 1

What are the two most important factors to consider in investment decisions?

Answer 1

Expected return and risk of the investment.

Question 2

What is the typical relationship between risk and return in investments?

Answer 2

A positive relationship; higher expected returns are usually associated with higher risk exposure.

Question 3

How is return calculated for an investment?

Answer 3

Return represents the expected benefits earned from an investment, taking the initial investment size into consideration.

Question 4

What is the formula to calculate the return of an investment?

Answer 4

Return = [(P1 - P0) + D1] / P0 × 100, where P0 = purchase price, P1 = sales price, D1 = total dividend revenue.

Question 5

What is a major disadvantage of the single-period return measure?

Answer 5

It does not take the time value of money into consideration.

Question 6

What is the internal rate of return?

Answer 6

A discount rate that makes the present value of all future receipts equal to the present price of the investment.

Question 7

What types of risks can affect investment returns?

Answer 7

Systematic risk and non-systematic risk.

Question 8

Define systematic risk.

Answer 8

Risks that result from changes in the total economy affecting all enterprises and investments, which cannot be controlled by individual enterprises.

Question 9

What is interest rate risk?

Answer 9

The probability that changes in interest rates will negatively affect the return on an investment.

Question 10

How can interest rate risk be reduced for fixed income securities?

Answer 10

By buying securities with a short remaining term or keeping them until maturity.

Question 11

Define cyclical risk.

Answer 11

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

Question 12

What methods can be used to reduce cyclical risk?

Answer 12

Diversification over time, diversification between different types of investments, and proper timing of purchases.

Question 13

How does diversification help with cyclical risk?

Answer 13

By investing in different asset types, as they may not experience ups and downs simultaneously.

Question 14

What is the benefit of understanding the relationship between risk and return in investing?

Answer 14

It helps investors make informed decisions about where to allocate their resources for optimal returns with manageable risk.

Question 15

What is inflation risk?

Answer 15

Inflation risk is the risk that the value of money decreases over time due to inflation, affecting the real rate of return on investments.

Question 16

Why should investors focus on the real rate of return during high inflation?

Answer 16

Investors should focus on the real rate of return to understand the actual growth of their investment after accounting for inflation, as a nominal return may not reflect true gains

Question 17

How is the real rate of return calculated?

Answer 17

Real rate of return = ((1 + inflation rate) / (1 + nominal return)) - 1.

Question 18

What approaches can hedge against inflation risk?

Answer 18

Approaches include international diversification, maintaining a balanced diversified portfolio, timing investments, and investing in inflation-linked securities.

Question 19

What is exchange rate risk?

Answer 19

Exchange rate risk is the uncertainty regarding returns for investors exposed to foreign securities due to fluctuations in currency exchange rates.

Question 20

How does exchange rate risk affect South African investors in U.S. Treasury securities?

Answer 20

If the Rand/Dollar exchange rate increases, the investor receives less value in Rand terms for their dollar-denominated coupon payments and principal.

Question 21

What strategies can investors use to mitigate exchange rate risk?

Answer 21

Strategies include obtaining exchange rate cover, analyzing the company’s exposure to exchange rate fluctuations, and international diversification.

Question 22

Define market risk.

Answer 22

Market risk is the risk that the market price of an investment will differ from its intrinsic value due to irrational investor behavior or external events.

Question 23

What strategies can protect against market risk?

Answer 23

Strategies include timing purchases during market deviations, adopting a long-term investment strategy, international diversification, and thorough analysis of shares.

Question 24

What is non-systematic risk?

Answer 24

Non-systematic risk arises from specific factors affecting a particular enterprise, which can be influenced or mitigated by the enterprise itself.

Question 25

What is operating risk?

Answer 25

Operating risk is the sensitivity of an enterprise’s operating profit to changes in market conditions, particularly for firms with high fixed costs.

Question 26

How can investors hedge against operating risk?

Answer 26

Investors should analyze an enterprise’s revenue stream and cost structure, avoiding companies with unstable revenues and high fixed costs.

Question 27

Explain financial risk.

Answer 27

Financial risk arises from the way an enterprise is financed, particularly if it has a significant amount of debt, which can increase instability in returns.

Question 28

What are positive and negative financial leverage?

Answer 28

Positive financial leverage occurs when debt costs are lower than the return on total assets, while negative financial leverage occurs when debt costs exceed this return.

Question 29

What is industry risk?

Answer 29

industry risk is the risk specific to particular industries that can impact companies within that sector, influenced by factors like raw material dependence and regulatory changes.

Question 30

How can investors hedge against industry risk?

Answer 30

Investors should stay informed about industry conditions and trends, allowing them to anticipate changes that could impact their investments.

Question 31

Name some other risk factors that can affect non-systematic risk.

Answer 31

Other risk factors include bad inventory control, changes in management, legal actions, weak liquidity, patent expirations, and outdated technology.

Question 32

What is the general relationship between risk and return in investments?

Answer 32

There is a positive relationship; higher risk usually requires a higher return.

Question 33

What do rational investors require when exposed to increased risk?

Answer 33

A higher return, typically above the return of a risk-free investment.

Question 34

What is a risk-free investment example?

Answer 34

Government bonds.

Question 35

What is a risk premium?

Answer 35

An additional return required by an investor for taking on more risk than a risk-free investment.

Question 36

How do risk-averse and risk-seeking investors differ in terms of risk premium?

Answer 36

Risk-averse investors require a larger premium, while risk-seeking investors require a smaller premium.

Question 37

What does Beta (β) indicate in stock analysis?

Answer 37

The sensitivity of a stock’s price relative to changes in the market.

Question 38

What is the significance of a β value greater than 1?

Answer 38

The share is more sensitive to market changes than the market itself.

Question 39

What does a β value less than 1 indicate?

Answer 39

The share is less sensitive to market changes than the market itself.

Question 40

What does β = 1 signify?

Answer 40

Share prices move in tandem with the market.

Question 41

In what market conditions might investors prefer shares with high betas?

Answer 41

During a bull market, for higher price increases.

Question 42

When is it more advantageous for investors to buy shares with low betas?

Answer 42

During a bear market, to minimize price decreases.

Question 43

What other factors might an investor consider alongside beta when making investment decisions?

Answer 43

Current market value and intrinsic value of the company’s shares.

Question 44

Why is it important for investors to stay informed about market conditions?

Answer 44

Market conditions change continuously, affecting investment decisions.