Investment basis Flashcards
Pure risk
A category of risk in which loss is the only possible outcome; there is no beneficial result. Pure risk is related to events that are beyond the risk-taker’s control and, therefore, a person cannot consciously take on pure risk.
For example, the possibility that a person’s house will be destroyed due to a natural disaster is pure risk. In this example, it is unlikely that there would be any potential benefit to this risk.
There are products that can be purchased to mitigate pure risk. For example, home insurance can be used to protect homeowners from the risk that their homes will be destroyed.
Other examples of pure risk events include premature death, identity theft and career-ending disabilities.
Speculative Risk
A category of risk that, when undertaken, results in an uncertain degree of gain or loss. All speculative risks are made as conscious choices and are not just a result of uncontrollable circumstances.
By definition, almost all investment activities involve speculative risks, as an investor has no idea whether an investment will be a blazing success or an utter failure. However, some investments are more speculative than others. For example, investing in government bonds has much less speculative risk than investing in junk bonds, because government bonds have a much lower risk of default.
Rule of thumb
The higher the risk, the higher the potential return, but the less likely you are to achieve the higher return.
Risk Premium
-difference between the risk-free rate of return and the expected yield of an investment with risk
The return in excess of the risk-free rate of return that an investment is expected to yield. An asset’s risk premium is a form of compensation for investors who tolerate the extra risk - compared to that of a risk-free asset - in a given investment.
Think of a risk premium as a form of hazard pay for your investments. Just as employees who work relatively dangerous jobs receive hazard pay as compensation for the risks they undertake, risky investments must provide an investor with the potential for larger returns to warrant the risks of the investment.
For example, high-quality corporate bonds issued by established corporations earning large profits have very little risk of default. Therefore, such bonds will pay a lower interest rate (or yield) than bonds issued by less-established companies with uncertain profitability and relatively higher default risk.
Inflation
overall increase in the price of goods and services over time
Sources of Risk
- Changing Economic Conditions:
Interest rate risk, Market Risk
2.Changing Conditions of the Issuer (firm specific risk):
Default Risk or Credit Risk, Business failure risk, Liquidity Risk
Interest rate risk
Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall and vice versa. The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate. For example, a 5% bond is worth more if interest rates decrease since the bondholder receives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates.
Market Risk
The risk that the value of your investment will decrease due to changes in the market
Default Risk or Credit Risk
Risk that the company invested in may declare
bankruptcy
Business failure risk
bad management or products affect stocks
and corporate bonds
Liquidity Risk
The risk that you will not be able to sell an investment quickly without substantially affecting the investment’s value
Real estate and other assets which do not have a readily available market are not liquid
liquid asset
One that can readily be converted to cash
Risk Tolerance
How much you can afford to lose
Diversification
By owning a variety of investments, spreading
out the risk across multiple investments
Portfolio
Holding more than one investment
