P2B.1 Risk & Return Flashcards
Risk Definition
- Risk is the chance that an outcome will differ from an expected outcome or return.
- Can be measured using statistical tools such as variance and standard deviation.
Business Risk
Major uncertainties in the economy and how projects might be affected by these uncertainties.
- Degree of operating leverage
- Variability in consumer demand
- Price variability
- Impact of inflation on input prices
Systematic Risk
- Attributable to the market, undiversifiable and can’t be predicted or avoided.
- Includes interest rate risks, inflation, war and recession.
- Measured by the covariance between security’s return and market.
Unsystematic Risk
- Attributable specifically to a company, unique, diversifiable and avoidable.
- No correlation between these risks and market wide factors.
- Can be reduced by diversifying the investment.
- Includes poor management decisions, labor strikes and industry regulation changes.
Credit Risk
Risk of loss due to inability to repay a loan or failure to adhere to debt agreements.
Foreign Exchange Risk
Risk that particular currency loses its value relative to another currency.
Interest Rate Risk
Risk that a change in market interest rates can significantly reduce value of an investment.
Market Risk
Risk that value of an investment will change because overall market performance.
Industry Risk
Risk that the industry’s performance may negatively affect the investment of a company.
Political Risk
Risk that political actions and government rules and regulations will affect the performance of an entity and its investments.
Value at Risk (VaR)
The maximum loss within a given period of time and given a specified probability level (level of confidence).
Rate of Return
- Rate at which an asset or capital generates income.
- Calculated on an annual basis.
- The greater the risk, the greater the potential return.
Rate of Return Formula
= Income / Average Investment Income
Relationship between Risk & Return
- Directly related; strong positive relationship.
- High risk, high return: stocks
- Low risk, low return: government bonds and treasury notes.
Standard Deviation
Statistical measure of variability or tightness of a distribution of outcomes around a central measure, the expected return.
Coefficient of Variance (CV)
Measures the relative risk per expected return.
= Standard deviation / Expected return
Diversification
- Can’t eliminate risk, but can reduce it.
- Replaces individual risk with a number of different risks.
- Gains can help offset losses (variances)
Capital Asset Pricing Model (CAPM)
- Financial model used in calculating the expected risk-adjusted returns.
- Based on time value of money concept and risk (risk free rate and beta)
Capital Asset Pricing Model (CAPM) Formula
R = RF + β(RM − RF )
R = Expected return RF = Risk free rate of return RM = Market Rate (RM − RF ) = Market risk premium β = Beta coefficient, systematic (undiversifiable) risk
Beta Analysis
- Measure of individual stock volatility.
- Debt to equity ratio, industry characteristics and operating leverage will have impact on beta.
β > 1 High risk multiplier of stock price, highly volatile
β < 1 Low risk multiplier of stock price, less volatile
β = 1 Market & stock price move perfectly to changes in market
β = 0 No correlation of stock & market price
β < 0 Stock price moves inversely with that of the entire market
Yield Curve
Plots the interest rate of bonds that have equal credit quality at a set period of time, but differing maturity dates.
What are the three main patterns created by the interest rate term structure?
- Normal yield curve—this forms during normal market conditions.
- Flat yield curve—this forms when the market is sending mixed messages to investors.
- Inverted yield curve—this forms during extraordinary market conditions.
Common measures of Risk
Individual: expected return & standard deviation
Portfolio: covariance & correlation
Correlation
Statistical measure of the degree in which two investments move in relationship to each other.
