Investment Risks

Question 1

Interest rate risk

Answer 1

risk of fluctuations in security prices because of market interest rate changes. Affects bond prices inversely. Since increases in interest rates affect all securities the same way, it’s hard to eliminate interest rate risk and is a type of systematic risk.

Question 2

Reinvestment risk

Answer 2

Not knowing interest rate for reinvesting after maturity

Question 3

Inflation risk

Answer 3

Likelihood that rising prices will outpace purchasing power of money, systematic risk

Question 4

Business risk

Answer 4

Fluctuations in investment value caused by management decision or firm’s product performance in the marketplace. Unsystematic/diversifiable risk

Question 5

Tax risk

Answer 5

unexpected tax liability: unsystematic risk as this is borne in asset-specific situations ie pooled investments/mutual funds

Question 6

Investment manager risk

Answer 6

asset specific, eg style drift: unsystematic risk

Question 7

Financial risk

Answer 7

Use of debt by firms: unsystematic since specific to the company

Question 8

Liquidity risk

Answer 8

Inability to sell a security quickly and at FM price: unsystematic

Question 9

Market risk

Answer 9

Overall market movements measured by beta; systematic risk

Question 10

Political and regulatory risk

Answer 10

Unanticipated changes in tax/legal environments imposed by government; unsystematic since it depends on size/scope of regulation change

Question 11

Exchange rate risk

Answer 11

For the international investor, exchange rate risk is simply another layer of risk

Question 12

Sovereign risk

Answer 12

Possibility of foreign country’s collapse

Question 13

Call/prepayment risk

Answer 13

Risk to bondholders that bond may be called before maturity; overlaps with reinvestment risk

Question 14

Normal distribution and standard deviation

Answer 14

Mean=median, 68% within 1 standard deviation
95% within 2
99% within 3

Question 15

Skewness

Answer 15

Positively skewed with outliers in upper/right tail
Negatively skewed with outliers in lower/left tail

Question 16

Lognormal distribution

Answer 16

Described by mean and variance of its associated normal distribution

Question 17

Deviations

Answer 17

1: 68%
2:95%
3:99.7%
Variance of an asset’s rate of return is a statistic that measures the asset’s wideness, represented by s squared and VAR(r)

Question 18

Kurtosis

Answer 18

Statistical measure noting when a distribution is more or less peaked than a normal distribution:
Mesokurtic: normal (kurtosis=3/ excess kurtosis=0)
Leptokurtic: more peaked/slender: fat tails (excess kurtosis>0)
Platykurtic: less peaked/broader (excess kurtosis<0)

Question 19

Co-variance

Answer 19

Tendency for two random variables to move together

Question 20

Semi-variance

Answer 20

asset performing below expected/average return, downside risk

Question 21

Correlation coefficient

Answer 21

Standardized index number from-1 to 1 measuring covariance, represented by rho

Question 22

Beta coefficient

Answer 22

Index of undiversifiable (market/systematic) risk
Bm=1 = Beta of market: if Bi=1, then asset has same volatility of the market
If Bi>1, then aggressive asset: return will be higher than the market if market return increases, but will also decrease more when the market return decreases
If Bi<1, then defensive asset, will increase/decrease less than the market

Question 23

Coefficient of Determination

Answer 23

The portion of the asset’s performance attributed to overall market returns, also called correlation coefficient squared
If R-squared=1, the asset’s return is perfectly correlated with the return of the market, closer to one, then the more reliable its beta; if <.7, then Beta and Treynor’s ratio and Jensen’s alpha (which use Beta) would be a meaningless statistic
If R-squared=0, the asset’s return has nothing to do with the market’s return

Question 24

Diversifiable Risk (Unsystematic)

Answer 24

Can be eliminated through diversification since it results from idiosyncratic fluctuations unique to a particular stock (sources include business/financial/default/credit/regulation/sovereign risk. The diversifiable risk/residual variance/standard error squared/VAR(e)/ Percentage of total risk that is diversifiable=1-coefficient of determination

Question 25

Nondiversifiable Risk (Systematic)/un-diversifiable

Answer 25

Purchasing Power Risk (Inflation Risk)
Reinvestment Rate Risk
Interest Rate Risk
Market Risk
Exchange Rate Risk
(PRIME) measured by coefficient of determination/R-squared

Question 26

Expected rate of return

Answer 26

weighted average of various rates of return in one probability distribution

Question 27

Alpha

Answer 27

value on the vertical axis where the characteristic line intersects that axis

Question 28

What is used to measure an investment’s beta and residual variance?

Answer 28

Characteristic line is a simple linear regression used to measure an investment’s beta and residual variance

Question 29

At the beginning of the year, one U.S. dollar could buy 80 Japanese yen. At the end of the year, one U.S. dollar could buy 100 Japanese yen. What happened to the U.S. dollar during the year?

Answer 29

The U.S. dollar was revalued. Revaluation refers to an increase in the currency’s value.

Question 30

What is considered a liquidity ratio?

Answer 30

Working Capital = current assets - current liabilities
Current Ratio = current assets ÷ current liabilities
Quick Ratio = (current assets - inventory) ÷ current liabilities. (This ratio is also known as the acid test.)
Cash Ratio = (cash + marketable securities) ÷ current liabilities