Investments Topic 7 - Risk

Question 1

The equity risk premium (ERP) is the difference between

Answer 1

equities and low-risk investments (gilts) in relation of risk taken

Question 2

3 areas of risk in financial sector

Answer 2

• Investment – probability of not/achieving expected return on investment
• Operational – risk of losses as a cause of internal processes, people and systems
• Business/reputational – the exposure that a company has to factors that will lower profits

Question 3

Capital risk

Answer 3

when there is a risk of losing some or all of the original investment. Only fix to this is investing into deposit accounts, which causes inflation risk.

Question 4

Income risk, comes in 2 forms

Answer 4

• Risk that income from investments will reduce e.g. variable interest investments may decrease income
• Risk that income generated from investments will not keep up with inflation rates

Question 5

Shortfall risk

Answer 5

where investments may not meet investors’ expectations, such as the endowment scandal for interest-only mortgages. Riskier investments typically include shortfall risk, whereas deposit accounts don’t

Question 6

Liquidity and access risk

Answer 6

liquidity refers to the ability to turn the investments into cash quickly. Access refers to whether the investor can freely access the money in an investment

Question 7

Interest risk, shown in 2 ways

Answer 7

• Savers in variable rate accounts may suffer from bad rates
• Savers in fixed-rate accounts with penalties can suffer if general rates increase

Question 8

Inflation risk

Answer 8

risk that the real value of money will fall in investments

Question 9

Currency risk

Answer 9

risk that investments overseas can be eroding if the currency moves up/down

Question 10

Systemic risk

Answer 10

where an individual’s action can affect the wider system altogether. Creates a domino effect, exactly like the failure of Lehmann Brothers in 2008.

Question 11

Systematic risk

Answer 11

sometimes known as market risk, and it is when events will cause share prices and other asset values to fall even though the companies remain solvent. Examples can be wars, recession, inflation etc.

Question 12

Key difference between systemic and systematic risk

Answer 12

systemic starts with failure of one individual within the market that sets off a chain reaction whereas systematic is an external event which causes sector-wide changes.

Question 13

Non-systematic risk

Answer 13

relates to risk of an individual investment/sector collapsing and prices decreasing. For example changes in company policy or companies collapsing will reduce value of shares for that company only

Question 14

Gearing

Answer 14

Term used when a company borrows to invest and is expressed by showing borrowing as a percentage of capital and reserves

Question 15

Volatility is measured by

Answer 15

its standard deviation from its benchmark/average trade price, known as the expected return

Question 16

Standard deviation is

Answer 16

a mathematical equation that helps to establish how far the share price has deviated from its average, and this lets you know how volatile the share currently is.

Question 17

2 main measures of volatility:

Answer 17

• Alpha
• Beta

Question 18

Beta factors:
(The measurement system for Beta)

Answer 18

• Beta factor 1 – where the holding moves in line with the market or index
• Beta factor over 1 – where the holding fluctuates more widely than the benchmark, making it more volatile
• Beta factor below 1 – where the holding fluctuates less than the benchmark

Question 19

Calculation for alpha performance measurement

Answer 19

Question 20

In order to calculate the present or future value of money, you will need to know any four of:

Answer 20

• Interest rate
• Payment(s) amount
• Number of payment periods
• Present value
• Future value

Question 21

Simple interest

Answer 21

when interest added is based on the ORIGINAL CAPITAL each year. E.g. investment of £1,000 at 4% interest would be £1,040 on first year, £1,080 on second year and £1,120 on third year.

Question 22

Compound interest

Answer 22

when interest is added to the capital and interest earns interest itself.

Question 23

Discounting

Answer 23

opposite of compounding but can use compound interest tables to work out. Shows how much must be invested now to gain certain amount in the future.

Question 24

Pound cost averaging

Answer 24

– buying investments over a longer time period and drip feeding them in instead of buying them all at once. This is so that if the market declines sharply, only the amount that has currently been invested gets affected