Component 6: risk & return Flashcards
What are the two most important factors to consider in investment decisions?
Expected return and risk of the investment.
What is the typical relationship between risk and return in investments?
A positive relationship; higher expected returns are usually associated with higher risk exposure.
How is return calculated for an investment?
Return represents the expected benefits earned from an investment, taking the initial investment size into consideration.
What is the formula to calculate the return of an investment?
Return = [(P1 - P0) + D1] / P0 × 100, where P0 = purchase price, P1 = sales price, D1 = total dividend revenue.
What is a major disadvantage of the single-period return measure?
It does not take the time value of money into consideration.
What is the internal rate of return?
A discount rate that makes the present value of all future receipts equal to the present price of the investment.
What types of risks can affect investment returns?
Systematic risk and non-systematic risk.
Define systematic risk.
Risks that result from changes in the total economy affecting all enterprises and investments, which cannot be controlled by individual enterprises.
What is interest rate risk?
The probability that changes in interest rates will negatively affect the return on an investment.
How can interest rate risk be reduced for fixed income securities?
By buying securities with a short remaining term or keeping them until maturity.
Define cyclical risk.
The probability that returns will be negatively influenced by changes in the economic cycle
What methods can be used to reduce cyclical risk?
Diversification over time, diversification between different types of investments, and proper timing of purchases.
How does diversification help with cyclical risk?
By investing in different asset types, as they may not experience ups and downs simultaneously.
What is the benefit of understanding the relationship between risk and return in investing?
It helps investors make informed decisions about where to allocate their resources for optimal returns with manageable risk.
What is inflation risk?
Inflation risk is the risk that the value of money decreases over time due to inflation, affecting the real rate of return on investments.
Why should investors focus on the real rate of return during high inflation?
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
How is the real rate of return calculated?
Real rate of return = ((1 + inflation rate) / (1 + nominal return)) - 1.
What approaches can hedge against inflation risk?
Approaches include international diversification, maintaining a balanced diversified portfolio, timing investments, and investing in inflation-linked securities.
What is exchange rate risk?
Exchange rate risk is the uncertainty regarding returns for investors exposed to foreign securities due to fluctuations in currency exchange rates.
How does exchange rate risk affect South African investors in U.S. Treasury securities?
If the Rand/Dollar exchange rate increases, the investor receives less value in Rand terms for their dollar-denominated coupon payments and principal.
What strategies can investors use to mitigate exchange rate risk?
Strategies include obtaining exchange rate cover, analyzing the company’s exposure to exchange rate fluctuations, and international diversification.
Define market risk.
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.
What strategies can protect against market risk?
Strategies include timing purchases during market deviations, adopting a long-term investment strategy, international diversification, and thorough analysis of shares.
What is non-systematic risk?
Non-systematic risk arises from specific factors affecting a particular enterprise, which can be influenced or mitigated by the enterprise itself.
What is operating risk?
Operating risk is the sensitivity of an enterprise’s operating profit to changes in market conditions, particularly for firms with high fixed costs.
How can investors hedge against operating risk?
Investors should analyze an enterprise’s revenue stream and cost structure, avoiding companies with unstable revenues and high fixed costs.
Explain financial risk.
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.
What are positive and negative financial leverage?
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.
What is industry risk?
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.
How can investors hedge against industry risk?
Investors should stay informed about industry conditions and trends, allowing them to anticipate changes that could impact their investments.
Name some other risk factors that can affect non-systematic risk.
Other risk factors include bad inventory control, changes in management, legal actions, weak liquidity, patent expirations, and outdated technology.
What is the general relationship between risk and return in investments?
There is a positive relationship; higher risk usually requires a higher return.
What do rational investors require when exposed to increased risk?
A higher return, typically above the return of a risk-free investment.
What is a risk-free investment example?
Government bonds.
What is a risk premium?
An additional return required by an investor for taking on more risk than a risk-free investment.
How do risk-averse and risk-seeking investors differ in terms of risk premium?
Risk-averse investors require a larger premium, while risk-seeking investors require a smaller premium.
What does Beta (β) indicate in stock analysis?
The sensitivity of a stock’s price relative to changes in the market.
What is the significance of a β value greater than 1?
The share is more sensitive to market changes than the market itself.
What does a β value less than 1 indicate?
The share is less sensitive to market changes than the market itself.
What does β = 1 signify?
Share prices move in tandem with the market.
In what market conditions might investors prefer shares with high betas?
During a bull market, for higher price increases.
When is it more advantageous for investors to buy shares with low betas?
During a bear market, to minimize price decreases.
What other factors might an investor consider alongside beta when making investment decisions?
Current market value and intrinsic value of the company’s shares.
Why is it important for investors to stay informed about market conditions?
Market conditions change continuously, affecting investment decisions.
