Investment Risks Flashcards
Interest rate risk
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.
Reinvestment risk
Not knowing interest rate for reinvesting after maturity
Inflation risk
Likelihood that rising prices will outpace purchasing power of money, systematic risk
Business risk
Fluctuations in investment value caused by management decision or firm’s product performance in the marketplace. Unsystematic/diversifiable risk
Tax risk
unexpected tax liability: unsystematic risk as this is borne in asset-specific situations ie pooled investments/mutual funds
Investment manager risk
asset specific, eg style drift: unsystematic risk
Financial risk
Use of debt by firms: unsystematic since specific to the company
Liquidity risk
Inability to sell a security quickly and at FM price: unsystematic
Market risk
Overall market movements measured by beta; systematic risk
Political and regulatory risk
Unanticipated changes in tax/legal environments imposed by government; unsystematic since it depends on size/scope of regulation change
Exchange rate risk
For the international investor, exchange rate risk is simply another layer of risk
Sovereign risk
Possibility of foreign country’s collapse
Call/prepayment risk
Risk to bondholders that bond may be called before maturity; overlaps with reinvestment risk
Normal distribution and standard deviation
Mean=median, 68% within 1 standard deviation
95% within 2
99% within 3
Skewness
Positively skewed with outliers in upper/right tail
Negatively skewed with outliers in lower/left tail
Lognormal distribution
Described by mean and variance of its associated normal distribution
Deviations
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)
Kurtosis
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)
Co-variance
Tendency for two random variables to move together
Semi-variance
asset performing below expected/average return, downside risk
Correlation coefficient
Standardized index number from-1 to 1 measuring covariance, represented by rho
Beta coefficient
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
Coefficient of Determination
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
Diversifiable Risk (Unsystematic)
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
