Module 1 - Investment Risk and Return Analysis

Question 1

Unsystematic Risk

Answer 1

A.K.A. -
- Diversifiable Risk
- Unique Risk
This type of risk can generally be reduced or eliminated by adding additional securities to a portfolio. Lower correlation securities will have a greater impact on reducing this risk.
Measured by Standard Deviation (variability)
Business Risk, Financial Risk, Default Risk, Credit Risk, Political Risk, Liquidity Risk, Marketability Risk, Event Risk, Tax Risk, Investment Manager Risk

Question 2

Systematic Risk

Answer 2

A.K.A. -
- Non-Diversifiable Risk
This type of risk is inherent in the global marketplace and cannot be reduced or eliminated through adding additional securities to a portfolio.
Measured by Beta (volatility)
Purchasing Power Risk (inflation), Reinvestment Risk, Interest Rate Risk, Market Risk, Exchange Rate Risk (PRIME)

Question 3

Endogenous Risk

Answer 3

This type of risk is a result of irrational investor behavior within the marketplace. Herd behavior can lead to panic in the marketplace leading to shocks which are amplified throughout the financial system.

Question 4

Diversification

Answer 4

A method used to reduce unsystematic risk and increase returns.

Question 5

Risk and Return Considerations

Answer 5

An advisor must look at both risk and return when considering investments. Never evaluate one without the other. CV (coefficient of variation) is a good method to determine risk adjusted returns. Calculated by dividing the standard deviation by the mean return.

Question 6

Purchasing Power Risk

Answer 6

A.K.A. - Inflation Risk
The risk that purchasing power may be lost due to a general rise in price levels. This type of risk mainly impacts investments with fixed rates of returns, especially bonds (except TIPs and IBonds). CPI is widely used to measure inflation.

Question 7

Reinvestment Risk

Answer 7

A.K.A. - Reinvestment Rate Risk
The risk of reinvesting cash flows at a lower rate than was previously earned. Inversely related with Interest Rate Risk. When interest rates rise, bond prices decrease, but reinvestments are made earning a higher rate. Conversely, when interest rates decline, reinvestments are made earning a lower rate.

Question 8

Interest Rate Risk

Answer 8

The risk that fluctuations in prevailing interest rates having an inverse effect on asset prices. Generally applies to fixed income investments such as bonds. As interest rates rise, the price of fixed income assets decline. The longer the maturity (lower coupon), the more sensitive a fixed income asset’s price will be to a change in interest rates.

Question 9

Market Risk

Answer 9

The risk of asset price movements based on macroeconomic influences. Well positioned stocks can be negatively influenced by overall poor market news. Conversely, mediocre stocks can benefit from overall positive market news.

Question 10

Exchange Rate Risk

Answer 10

A.K.A. - Currency Risk
The effect of currency valuations on foreign investments. Generally speaking, a weaker dollar will have a positive impact on foreign investments for a U.S. investor. Conversely, a strengthening dollar will have a negative impact.

Question 11

Business Risk

Answer 11

This risk is concerned with the general uncertainty associated with a firm’s management and financial structure, as well as their ability to pay dividends or interest to investors. The ability of the company to successfully market can also be included in this risk.

Question 12

Financial Risk

Answer 12

This risk generally revolves around a firm’s usage of leverage (debt) to finance operations. A more leveraged firm may produce higher return on equity on less net income. However, the leverage is a drag on the firm, requiring more income to generate returns for investors (because interest payments on the debt must be met first). Gains and losses are amplified by leverage.

Question 13

Default Risk

Answer 13

This risk is closely associated with the financial condition of a firm. Weaker financial condition means higher chance of default. Generally applies to bonds, but can also apply to commercial paper, lease and loan obligations. Default leads to bankruptcy proceedings.

Question 14

Credit Risk

Answer 14

This risk is closed associated with default risk. Credit ratings (like personal credit scores) can have a positive or negative impact on asset prices (like stocks). Changes in rating can have a significant impact.

Question 15

Political Risk

Answer 15

A.K.A. - Country Risk
This is the risk associated with the uncertainty of political, economic, and social structure of a given location. The more uncertainty, the greater the risk. War, corruption, riots, law changes can all have an impact.

Question 16

Liquidity Risk

Answer 16

The degree of uncertainty around how long it will take to sell an asset with minimum capital loss. It is also used to describe safety of principal.

Question 17

Marketability Risk

Answer 17

Risk associated with the ability to sell a security based on the activity within the market. Low market activity for a security (thinly traded) may make it difficult to liquidate. Marketability and liquidity can be closely related.

Question 18

Event Risk

Answer 18

The risk that some unpredictable event can have an impact on an investment’s value.

Question 19

Tax Risk

Answer 19

Risk associated with complex and often unclear interpretation of tax legislation. In an effort to take advantage of tax loopholes or innovative tax strategies, an investor can open themselves up to potential back taxes and penalties.

Question 20

Investment Manager Risk

Answer 20

Risk associated with decisions by a portfolio manager.

Question 21

Weighted Average Calculation Steps

Answer 21

Return is entered as INPUT
Weighting is entered as Sigma+
After all entries are made, enter gold/6 to calculate the weighted average return

Question 22

Standard Deviation

Answer 22

Measurement of variability around the mean return of an asset or a portfolio

Question 23

Normal Distribution

Answer 23

Used to depict asset/portfolio returns (%). Allows for both positive and negative values.

Question 24

Lognormal Distribution

Answer 24

Used to depict asset/portfolio values ($). Only allows for positive values because an investment cannot drop below zero (without leverage).

Question 25

Skewness

Answer 25

The degree to which a distribution graphic is asymmetrical. Positive skew distribution has a long tail to the right (indicating positive outliers), whereas a negative skew distribution has a long tail to the left (indicating negative outliers). Positive skewness - Mean>Median>Mode. Negative skewness - Mean<Median<Mode.

Question 26

Kurtosis

Answer 26

The degree to which a distribution graphic is tall and narrow (leptokurtic) indicating results that are bunched around the mean with less variability, or short and rounded (platykurtic - like a plate) indicating a more wide dispersion around the mean.

Question 27

Semivariance

Answer 27

Measurement of risk that is only concerned with lower than expected returns. Only returns less than the mean return are considered.

Question 28

Coefficient of Variation

Answer 28

Risk adjusted return measurement. Divide the standard deviation by the mean return.

Question 29

Covariance

Answer 29

Measures the extent to which two variables are related (generally stocks or mutual funds). Also measures how the price movements of one relate to the other.

Question 30

Correlation Coefficient

Answer 30

Also known as R, it is the statistical measure of the strength of the linear relationship between two variables. Used to calculate Covariance. Square it to calculate the coefficient of determination. Ranges from 1 (perfectly positively correlated) to -1 (perfectly negatively correlated). An R of 0 indicates no relation. The lower the R, the more diversified two variables are, and thus less risk.

Question 31

Changing Correlations

Answer 31

Correlations are not stagnant. They move. Long-term correlations can be misleading if correlations have recently changed. Correlations are also inconsistent in rising and falling markets. Short-term correlation variations can be significant. Over time, variations are reduced. See William Coaker’s work on tracking correlations between International and Emerging Market Stocks vs. the S&P 500.

Question 32

Coefficient of Determination

Answer 32

R Squared. Indicates the percentage of one’s assets that can be explained by the movement of a second asset. Generally the second asset is a market index or benchmark. A stock with a .70 R-squared indicates that Beta is a usable measure, and that 70% of the stock’s movement can be explained by the systematic risk of the index or benchmark it is being compared to. The remaining 30% can be explained by other, non-systematic risks (usually assumed to be the portfolio manager).

Question 33

Standard Deviation of a Portfolio

Answer 33

If COV is 1, you can take the weighted average of the standard deviation of the individual securities. Otherwise, use the formula to solve.

Question 34

Beta Coefficient

Answer 34

Measures the volatility of an asset is compared to another (typically a benchmark). It is a measure of systematic risk. A beta of 1 means a security’s volatility (and therefore return) is expected to match that of the market. A beta of greater than one indicates more volatility than the market (which should be compensated with more return). A beta less than one indicates less volatility. A negative beta indicates volatility that is in the opposite direction of the market.

Question 35

Weighted Average Beta Calculation (using the calculator)

Answer 35

Enter the Beta coefficient as Input, enter the weighting as Sigma+. Once all entries are complete, hit gold and then 6 key.

Question 36

Smart Beta

Answer 36

This is the use of indexing and active investing strategies together. The idea is to try to outperform an index by overweighting and underweighting. Anomalies are often part of a smart beta strategy.

Question 37

Modeling

Answer 37

Used to develop an optimistic, pessimistic and most probable outcome for a base scenario. Can be used in capital market analysis, retirement planning and investment management.

Question 38

Sensitivity Analysis

Answer 38

Used to evaluate the risk associated with a given investment by assessing the impact of different variables on the investment’s returns. Changes in variables can be evaluated and scrutinized. Investors may choose an investment based on the reliability of the outcome for a given variable.

Question 39

Stochastic Modeling

Answer 39

Financial analysis that attempts to forecast how investment returns on different asset classes vary over time by running thousands of simulations to produce probability distributions for various outcomes.

Question 40

Monte Carlo Simulation (MCS)

Answer 40

Method of Stochastic Modeling used in retirement planning that uses random variable inputs (returns, inflation rates, spend rates, etc.) to generate multiple outcomes and their probabilities. This allows for a more real-world approach and analysis of potential outcomes versus the deterministic method that uses single and unchanging variable inputs.

Question 41

Building a Portfolio

Answer 41

Must pay attention to both risk and return. There is a correlation between risk and return. The more risk, the more expected return. In building a portfolio, you want to reduce/eliminate unsystematic risk, while minimizing standard deviation by adding assets that are not highly correlated. CV can be useful for this purpose. Another key is to have representation across industries. Mutual funds may or may not be appropriately diversified from an industry perspective.