Investment Risk Flashcards
The notion of investment risk must take into account the possibility that the return may be _______, _______ or _________.
positive (but greater or less than expected), zero, or negative.
Actuarial Risk
Risk an insurance underwriter covers
in exchange for premiums, such as the risk of premature death.
Agency Risk
Agency risk is the risk associated
when a principal delegates decisions to an agent who may not always act in the principal’s best interest. The most common principal-agent conflict in the investment management industry is between the client and the investment advisor.
Asset Class Risk
-Stocks, bonds, and cash are the three
major asset classes (but certainly not the only ones).
-If investors allocate a disproportionate amount to any of the three main categories, or totally ignore one or two of them, they are subject to asset class risk.
-It is generally prudent to diversify across all major asset classes, even when investors want to give primary emphasis to, say, stocks
Bid-Ask Spread Risk
-Securities sold over-the-counter
by investment banking houses that make a market in the shares are subject to the risk that the bid-ask price spread will change.
-Dealers charge one price, the ask price, when they sell these securities and another lower price, the bid price when they buy.
-The spread, or difference, is the profit the market maker gets for making the market in the security and helps to cover the market makers’ costs in maintaining an inventory of the securities.
Business (Company) Risk
-Business risk is an economic or operating risk reflected in the variability of a firm’s
earnings.
Changes in earnings or the variability of earnings may result in changes in the investing public’s perception of the company and sudden changes in the
price of the stock.
-In worst-case scenarios, companies may fail, leaving their stocks or bonds worthless.
-The best defense against this particular risk is to invest in more than one company and in companies engaged in different lines of business.
Management risk
–Financial difficulties can arise
from management’s inability to handle change or the failure to adapt to changing competitive conditions.
-Some companies are slow to take advantage of cost-cutting technologies and gradually become high-cost producers who are unable to survive in
a highly competitive marketplace.
Product or obsolescence risk
– Shifting demand or
changes in consumer tastes and preferences can quickly result in companies producing unwanted goods.
-Sometimes this risk is termed technological or innovative risk, as new innovations or technologies make a company’s products or processes no longer state-of-the-art.
Legislative/regulatory/tax risk
– Changes in the law
can affect a company’s fortunes.
-For example, if the federal government abandons protectionist policies that artificially raise the price of sugar in the United States to over forty-three cents a pound and allow U.S. companies to purchase sugar on world markets at world prices (around twenty-six cents a pound), the makers of corn sweeteners would suddenly find their companies unable to compete.
Financial risk
– This is the risk related to the mix of
debt and equity used by a firm to raise capital.
-The more debt in a firm’s capital structure, the greater its financial risk.
-Debt financing, as opposed to equity financing, obligates a firm to make periodic interest payments and to repay the amount borrowed at some future date.
Call (Prepayment, Redemption) Risk
-Many bonds and
some preferred stocks are issued with what is known as a call feature.
-The call feature gives the issuer the right to call the bond—to retire it after a certain date
or on several dates before maturity.
-Having the right to call the bond does not mean that the issuer has a duty or obligation to exercise the call.
-Generally, bonds will be called only when it is profitable for the issuer to do so.
-This occurs when interest rates have declined since the bonds were issued.
-The high interest issue is then called and replaced with a new issue that is sold at a much lower interest rate.
Country Risk
-This refers to the risk that a country
will not be able to honor its financial commitments.
-When a country defaults, it can harm the performance of all other financial instruments in that country, as well as other countries with which it has relations.
-Country risk applies to stocks, bonds, mutual funds, options, and futures that are issued within a particular country.
-In addition, this danger is associated with single-country mutual funds or closed-end funds and
ADRs sold or traded in the United States.
-This type of risk is most often seen in emerging markets or countries that have a severe deficit.
Credit or Default Risk
–This is the risk that a govern-
ment, company, or individual will be unable to pay the contractual interest or principal on its debt obligations.
-This type of risk is of particular concern to investors who hold bonds within their portfolio.
-Government bonds, especially those issued by the federal government, have the least amount of default risk and the lowest interest rates among bond issuers, while corporate bonds tend to have the highest amount of default risk, but also the higher interest rates.
Currency (Foreign Exchange) Risk
-Foreign holdings
may change in value as the value of currency changes.
-If the U.S. dollar grows stronger relative to foreign currencies, investors will experience a currency loss on their foreign securities.
Depth of Market Risk
–Depth of market risk is related
to bid-ask spread risk and is related to securities that are relatively thinly capitalized.
-An investor trying to sell a relatively sizeable position in a thinly capitalized
stock may find that there are not enough willing buyers at the current price to absorb his entire sale.
-Consequently, the very act of selling may depress the price and reduce the investor’s gain or increase his loss.
Discount or Premium Risk
-Closed-end investment
companies listed on organized exchanges or sold over the counter typically trade at values different from their Net Asset Values (NAV).
-The NAV is the value at which the securities underlying a share in the fund would trade if they were purchased directly in the market, rather than through the closed-end fund.
Documentation Risk
– The risk of loss due to an inadequacy or other unforeseen aspect involving the legal documentation of the financial contract.
Event Risk
– Mergers, acquisitions, and other major restructurings can significantly affect a specific investment asset.
-For example, when one firm announces its intention to acquire another, the share prices of both
companies are affected.
-This risk applies to bonds to some extent as well, but is not a consideration for other assets such as savings accounts and U.S. Treasury securities.
Financial Risk
– This is the risk related to the mix of debt and equity used by a firm to raise capital.
-The more debt is in a firm’s capital structure, the greater is its financial risk.
-Debt financing as opposed to equity financing obligates a firm to make periodic interest payments and to repay the amount borrowed at some
future date.
-Before a firm can distribute dividends to its common stockholders, it must meet its fixed-payment obligations.
-Failure to meet these obligations when they are due will result in the company’s insolvency or bankruptcy.
-The market’s perceived level of this risk affects not just the company’s cost of borrowing for bond issues and the value of its stock, but also the availability of lines of credit and financing for inventories and working capital, its credit terms with suppliers, and, ultimately, much of its cost of doing business.
Geographical or Location Risk
–This is the risk associ-
ated typically with real estate, where the old saw goes: the three most important elements are location, location, and location!
-However, it is a broader concept, as well, relating to regional economic factors.
- It is a smaller-scale version of country risk.
Industry or Sector Risk
– This risk relates to uncertain-
ties caused by particular features of the industry sector in which a company operates.
-These risks can vary dramatically. New technologies,
for example, are always going to expose investors to
higher uncertainty of future returns than the market
average—because of the inherent uncertainty of their new products and new markets—and they will certainly be more uncertain than food retailers
