Preface, ACC, Financial Markets Flashcards
1
Q
What is the actuarial control cycle
A
The Actuarial Control Cycle is a schematic approach based on a scientific approach to problem solving. Involves a feedback loop and the three stages:
Specifying the problem
Developing a solution
Monitoring the Experience
2
Q
Why are feedback loops important in actuarial work
A
Things in the context and environment change all the time and previous assumptions can become invalid. Revision is needed to refine or analyze your work.
The Actuarial Control Cycle must of course be considered in the context of the business, economic and commercial environment (e.g. legislation, taxation, business ethics).
3
Q
Explain specifying the problem as a part of the actuarial control cycle
A
Analyse the Risk
Assess Client’s Situation - Focus is on recognising, measuring, analysing and managing risks for your client.
Consider high-level options - Impact of risks and each potential solution on all stakeholders to be considered
Strategic courses of action are debated
4
Q
Explain Developing a solution as a part of the actuarial control cycle
A
Selection or construction of a model occurs, parameters are chosen and discuss assumptions
Calculate and interpret results- implications for all stakeholders
Determine solution proposed and main alternatives identified
Formal proposal/report
5
Q
What’s a dynamic strategy
A
Dynamic strategy is Contingent on happenings within the market. We will mostly consider static strategies this term
6
Q
Explain alpha risk
A
Alpha risk is when you think a fund manager outperforms the fund index. You think you’re picking a good manager to do better than the market and you take on alpha risk
7
Q
Explain monitoring the experience as a part of the actuarial control cycle
A
Compare with models previous
Review model - update with current experience
Give feedback into the problem specification
Review business context, update assumptions and identify causes of changes, are they likely to stick
Identify scope for improvement
Analyse the actual vs expected experience
After this step will either refine the initial solution OR a fresh look at the problem
8
Q
What is the extended actuarial control cycle
A
There is also an extended Actuarial Control Cycle separating insurance (actuarial risks like size of claims) to investment processes
9
Q
What are the two forms of actuarial investment advice generally given
A
1: To help clients construct a benchmark investment, and identify least risk strategy. Process is to meet clients, give advice, explain consequences, and write a report on this advice. ALWAYS identify the least risk investment strategies.
2: To give advice on how to outperform the benchmark return. Key assessment here is objective of client - can only win if others on market have different objectives
10
Q
When giving investment advice what are key practices
A
Advice must eb formally given
Client needs to understand the consequences of all decisions
Communication to non experts is key here
Always emphasize the randomness of the markets.
11
Q
What category of theory can be difficult to incorporate in a model
A
It’s very hard to incorporate the reflexive nature of theories into your model. Human nature is to follow each other, follow cascades or theories when they become widespread.
12
Q
Define neutral theories
A
Neutral Theories: Theories were no one, or some, or everyone believing in the theory has no impact on the phenomenon Ex: theory of compound interest.
13
Q
Define Reflexive theories
A
Reflexive Theories: So no one, or some, or everyone believing in the theory has an impact on the phenomenon. Reflexive theories can be divided into self-fulfilling theories, self-negating theories or a mix. Self fulfilling means the more that believe in it the more prominent it is. Self negating is the more people believe it the less true it becomes.
14
Q
Give an example of self fulfilling theory
A
Rational self-interest hypothesis (humans act rationally when making decisions involving their finances ) in economics…those who believe it act more selfishly than those who do not.
15
Q
Give an example of a self negating theory
A
Ex self negating: Any theory which claims a particular financial instrument offers
unusually low risk relative to its returns will tend to be self-negating: as demand for the investment ups its price, reducing expected returns and increasing its risk.
16
Q
What are the key attributes of an investor
A
The investor objectives are more important than the investment opportunity - reward and risk are defined by investor viewpoint.
Goal is “the highest possible return within an acceptable level of risk”.
Need to understand investor constraints.
Every individual will have an optimum strategy unique to them.
17
Q
Typically investors fund accumulate to meet liabilities so what aspects of investments and liabilities must be considered?
A
Nature of liabilities – real, monetary, static, going up with inflation?.
Term of liabilities
Currency of liabilities
Uncertainty in timing
Surplus
Regulation and Statutory Rules
Taxation
Expected Return from Assets
Contractual obligations
Ethical
Competitors
18
Q
What does system T stand for
A
Security, Yield, Spread (diversification), Term, Exchange rate, Marketability Taxation.
19
Q
Name lots of investment types
A
Cash, Money market instruments, government bonds, Corporate fixed interest bonds, index linked bonds, equities, property, currency (no income), commodities (no income), derivative instruments, pooling vehicles, other things
20
Q
Why is CAPM or efficient frontier not practical?
A
In reality you won’t know the inputs for CAPM or the efficient frontier optimisation, hence outputs cannot be estimated accurately.
21
Q
If you’re just solvent what should investment strategy be?
A
You only have funds available to meet your liabilities you should take MRP only. You do not have the capacity to take risks.
22
Q
What are the embedded risks in cash, bonds, equities, property and derivatives
A
Cash - small risk: counterparty risk and inflation risk are embedded
Bonds - Counterparty risk and inflation risk
Equity, property, derivatives - No promises, higher risk, equity risk, property risk etc
23
Q
Why does one have to be wary of using historical data?
A
Past behavior has to be interpreted as a reflexive model
Knowledge of the past affects the future so future will be different.
Data might look very different as economies were very different
Also remember in investing you’re trying to outwit and win over others and normally everyones relationships and key relationships will start based on historical data.
24
Q
Define a bond
A
A bond is a negotiable loan raised by some body, with generally fixed interest payments and redemption date (“fixed interest bonds”). There are several types.
So income from bonds is coupon payments and then there is a redemption amount at the end of the term. They are contracts to be enforced - need reliable parties.
Government bonds are gilts
They have low dealing costs generally
25
Define the term structure of interest rates
Term structure of interest - Describes the interest on government bonds for each future period giving us a platform for the future.
After about 20 years term the market gets a lot thinner.
26
How are bonds priced - talk about bond pricing and price changes
You buy in groups of 100 nominal.
Can buy bullet payments as stripped bonds.
Bond market can be prone to being heavily influenced by large trades.
The longer the bond the more dramatic the price change given a change in interest rates.
27
What is equity or an ordinary share
Equity or ordinary share – part ownership of the company with a right to vote on management of company, to participate in distributable profits of company and residual value on wind-up
Income from equities – dividends of uncertain amount
Keeps pace with inflation or economic growth perhaps.
Purely profiting by business activity.
28
Define quoted and unquoted shares
Quoted shares – those listed, regulated and traded on a recognised exchange.
Unquoted share means not listed.
29
What is creative destruction
Creative destruction means old companies go by the wayside when new companies come along, and they don’t contribute much to economy growth
Recycling of capital ideas - older companies offer more dividends as they are not in the growth stage. This capital gets put into newer companies.
30
Name a global equity index
FTSE Global Equity Index Series covers over 7,000 securities in 48 different countries and captures 98% of the world's investable market capitalisation.
31
What sort of mean should be used communicating returns to investors
Important to consider how you communicate real returns must convery the accumulation over the long term too.
Geometric averages < arithmetic average
Statistical mean is always arithmetic because of nice properties.
Geometric means will properly capture real losses
32
Name two world crashes of equities
From March 2000 to End 2002 – World equity markets (FTSE World) fall over 50%
From December 2007 to March 2009 – US Market falls 50% in Real terms
33
Explain why procyclicality is bad
Procyclicality means when things go badly most of the time it's a bad economy causing it so you won’t have money when you need it.
tendency of financial variables to fluctuate around a trend during the economic cycle
34
What is a money market instrument
A money market instrument is, in essence, a short-term loan
Prices quoted on a discounted basis
The number of days in a year is by convention. In the UK it's 365 and the US and Euro use 360.
35
What is the price quotes for a treasury bill in UK
Price Quoted for UK Treasury Bill= 100(1-(n/365)(d/100)) where n is no. of days outstanding and d is (annualised) discount rate
36
What is a repo
A repo is an agreement to repurchase bonds a few days after selling: determine lowest short term interest rate as there is essentially no risk of default on repos.
Interest rate is set at what you’re gonna buy it back at so it’s independent form the market - all to do with sale and repurchase agreement
Repo: sell and buy-back agreements to raise money on secure terms.
37
Who uses money markets
Central banks, governments, banks, companies (financial or otherwise), public agencies
Dominated by clearing banks : they borrow to cover a shortfall of liquid funds
Money markets are used to manage short term cash flows and liquidity
38
Characteristics of money markets
Excellent security : exposure time to credit worthiness of the borrower is limited
Yield: Close to interest rate set by monetary authorities and incorporates short term inflation expectation
Term: Most within 91 days
available in all currencies
Marketability: High
Volatility: Low as very short term
Tax: Taxed as income
39
Why would one hold cash?
Match known liabilities (Short term)
Liquidity requirements and you dont want to get haircut on assets.
Other: ex: if everything else is going down
Rising interest rates means the period is uncertain so people run to security or safe bets.
40
What will the reaction be to rising interest rates
Rising interest rates means the period is uncertain: people will question why the central bank is causing rates to rise. If there is uncertainty prices of securities go crazy generally so people run to security or safe bets.
Rising interest rates gives central bank control, disposable income decreases. Less inclined to borrow or invest which will push down demand for goods and services and lead to lower prices.
41
Why is controlling interest rates potentially asymmetrical
Rising interest rates gives central bank control however putting down interest rates can make it harder to stimulate the response you want. People won’t invest unless they see people spending.
Controlling interest rates one way is easier than the other as having free money is slightly problematic.
If people keep saving, investment doesn’t happen and demand reduces in the economy
42
Types of bonds
Conventional bonds, index linked bonds or Variable interest rate bonds .
Domestic Government bonds, Domestic corporate bonds, Foreign Domestic and Corporate bonds and Eurobond markets.
43
What is Ex-dividend/Cum-dividend and Clean/Dirty Price
Ex-dividend/Cum-dividend - day the stock starts trading without/with the value of its next dividend payment.
Clean/Dirty Price - the price of a bond excluding/including any interest accrued since bond's issuance and the most recent coupon payment
44
What are conventional government bonds traits
Bulk of bonds
Markets have high marketability (deep) - often matching asset
Generally used by institutional investors.
Government bonds are often tax free.
45
What are corporate bonds traits
Lower security than gilts and generally less marketability but yield is higher
Differences in Tax: Corporate can be taxed CGT and income.
Procyclicality applies: tendency of financial variables to fluctuate around a trend during the economic cycle
Only shorter terms normally available
46
How should one assess the security of corporate debt?
Security - secured or unsecured.
Do i hold any sort of priority in event of a wind up- Is it senior debt?
Credit ratings BB down are speculative junk bonds
Income cover
Capital cover
47
What is income cover
No. of times operating profit exceeds interest on loan and that on any more senior debt. Level of cover demanded depends on profit stability, company prospects, term of loan, yield, capital cover.
48
Explain capital cover
No. of times that the assets of co. (excluding intangibles and after notionally paying current liabilities) cover the loan and any prior ranking debt. Level demanded depends on the balance sheet values and quality of assets, term of loan, yield spread, income cover. Since it depends on balance sheet values you may adjust as ideally you want market values.
49
What are eurobonds and their traits
Eurobonds are underwritten by an international syndicate of banks who sell it on to their clients.
Annual interest paid gross, typically payments twice a year.
Not secured and sold OTC by banks
No trustees here, so depending on the company themselves
They are available as at fixed rates and FRNs
50
What are junk bonds
Junk bonds are those that do not satisfy reasonable demands of security (income or capital).
51
Explain index linked bonds and their traits
Coupon & redemption proceeds escalate in line with consumer price inflation, lagged a no. of months as we need to calculate the payments before they are due.
Typically, smaller issue sizes than conventional gilts – hence lower marketability.
They Quote real yields.
52
Explain strips
Strips – A stripped bond is a bond that has had its coupon payments and principal repayment "stripped" into two separate components that are then sold individually. Means you can buy capital or income spots.
53
What is stock lending
This is enabling some to ‘short’ a stock meaning sell what they do not own
54
What are yield curves the variations and traits
Yield curve – a graph of the (best-fit) GRY or IRR on gilts against unexpired terms.
Separate one drawn for high, medium, and low coupon bonds
Strip curve (or zero coupon curve or spot curve) also known as the term structure of interest rates is common.
Par yield curve – the coupon that would be required by the market for a gilt issued at par for the given term.
Yield curves can change very quickly
As yield goes down, price goes up and vice versa.
Yield curves are taking interest rates cumulatively compounded
55
What are three theories of yield curve shapes explaining changes in yield curves
Expectations Theory,Liquidity Preference Theory, Market Segmentation (or preferred habitat theory)
56
Explain expectations theory
Yield curve gives the market’s expectations for the future course of short-term interest rates. This is an application of the rational expectations hypothesis.
In particular, investor expectations of inflation affect both interest rate level and trends hence yield curve level and shape
57
By expectations theory if you believe short term interest rates to rise what action would you take?
If you believe that short term interest rates will rise you think the orange yield curve will result so you should invest long term: as yield drops the price goes up since demand goes up also..
58
Explain liquidity preference theory
Investors as a class prefer liquid assets to illiquid ones. Longer dated stocks are less liquid than shorter dated stocks hence yields should be higher on higher dated stocks. So investors prefer the capital security of shorter-dated stock
59
Explain market segmentation theory
Preferred habitat theory – yields at each term to redemption are determined by supply and demand from investors with (nominal) liabilities of that term.
Driven by the fact that investors have different needs. For example: Banks at short end and Life offices and pensions at long end of term. So investors go to that part of the maturity spectrum that match their liabilities and only tempted outside that maturity range by expected gains
60
Why might there be a hump in yield curve around 12 years
Since there was no institutional investor looking for around this term they wanted to draw people to this term.
Institutional investors generally went for short term debts (banks and building societies) or 15 year plus bonds (life offices)
Prices going up cause demand going up so yield will drop.
61
Why are the short and longer end of the yield curve quite anchored?
By preferred habitat theory - those terms are in demand. Shorter end anchored by Central bank short-term rate and its outlook in the short term.
Market does not know what will happen after 15 years, so prices do not vary much (level curve), as investors simply match the duration of their liabilities. Small upward slope may be for inflation risk premium.
The curve must be joined in the middle so it interpolates between the two well-established equilibria and is quite steep.
62
How can we combine all theories to explain yield curve shapes
Overall level of curve depends on inflation outlook (expectations theory)
Want compensation for uncertainty with an inflation risk premium (discount for some banks)
which is upward sloping with term (by liquidity preference theory)
Within this overall shape, near independence movements in the different maturity ranges –
in the different habitats (Market Segmentation)
63
Explain the real yield curve and relate real to nominal
The real yield curve you get index linked bonds and put price equal to future proceed solving for the real yield. Over the term.
three month lag
The difference between real and gross yield curves is the inflation risk premium and expected future inflation sum.
Nominal Yield = Real Yield + Expected future inflation + inflation risk premium
Conventional bonds will outperform ‘index-linkers’ if expectations of future inflation fall and vice versa - indirectly trading inflation expectations
64
Why are short term interest rates altered
Are set by central banks through repo rates and signalling. May alter rates to: To control inflation (high interest, strong exchange), to maximise economic growth (low interest and weak exchange). Want a balance here.
They may also be reduced to decrease the exchange rate.
There may be pressure from the government for political reasons to alter rate.
There may be a global tendency to reduce rates and central bank wants to keep currency/trading balance unchanged
Interest rates may also be reduced if the rate of inflation is lower than desired
65
What does a low short term interest rate mean
Central bank low interest rate means economic growth, more consumer spending.
Will create a weak exchange rate meaning you can export more.
Low real interest rates can also lead to inflationary pressures by increasing demand.
Should encourage investment spending by companies, so increased employment levels
Increase in the level of consumer spending because of: increased income due to a reduction in debt servicing costs, lower borrowing costs making borrowing more attractive, lower savings rate making savings less attractive.
Foreigners less likely to deposit money in that country so exchange rate will therefore fall - increasing competitiveness of exports but imported materials used will increase in price.
Relative competitiveness of domestically produced goods increases but cost of imports rises hence inflation on supply side
66
What happens a yield curve as short term interest increases
Gets flatter as it starts higher
67
What influences long term inetrest rates (and risk free yields basically)
Inflation: Bond investor wants compensation for its expected level
Inflation risk premium: Investors want compensation for uncertainty in inflation
Level of short-term interest rates (particularly bonds) - are they low, keeping check of inflation, or
high, and recession is imminent? (might be good for bond market)
Exchange rate and other yield curves for foreign demand.
Government’s fiscal position
Institutional cash flow on demand side: regulation, retail trends, investment policy.
Economic news
68
Whats the credit yield spread?
Difference between the risk free yield of a bond with same characteristics and a corporate bond yield
69
What additional factors affect bond prices because they affect the credit yield spread
Economic/business cycle in general.
Corporate and sector profitability in particular.
News affecting company and hence default risk, marketability etc
Pro-cyclicality of default risk
Ethical considerations
Size of issue
Possible changes to taxation
70
What are the formula for dividend cover and payout ratio
Dividend Cover = [profits for Ordinary Shares]/ (Total Cost of Dividends)
Payout ratio =1/[Dividend Cover]
71
Explain what operating gearing means and its effects
Operational gearing, describesrelation between fixed and variable costs. Highly geared: If high fixed costs means any change in turnover has a massive increase on profits in terms of percentage, ie operating profits are sensitive to turnover. Low gearing: As their variable costs are dominant, whenever they face low sales, their costs will significantly decrease
72
What is financial gearing/leverage and its effects
A company with a high ratio of fixed borrowings to equity. Hence profit is very sensitive to turnover.
If I change equities to bonds, I need to pay bond holders first.
73
How sensitive is the present value of dividends calculation
Very it’s a long term valuation so can change a lot with volatile markets. The expectation for dividends changes with new information
74
Explain the touch
The ‘touch’ also affects the equities marketability, that is the highest bid and lowest offer amongst all the market makers (market makers not really used anymore)
75
What will dealing costs depend on?
Market Impact
The bid/ask spread
Taxes
Costs of maintaining records
Mid-price is average of market offer & bid.
76
Explain a quote driven system vs order driven system
Quote-driven system – market makers quote two-way prices in stocks in which they are prepared to deal up to certain limits
Can’t use it if the market is going crazy as hard to make trades: People will widen spread and not take orders.
Order-driven system – buyers and sellers list the price and quantity they wish to deal and they are electronically matched,computer based,
77
Name some industries to consider in your equity lassification system
Resources
Basic industries
General Industries
Consumer Goods: Cyclical (only when things are going well) Consumer Goods, Non-Cyclical Consumer Goods
Services: Cyclical Services, Non-Cyclical Services
Utilities
Financials
Information Technology
78
Principal Influences on Equity Market prices
General price level in market set by supply & demand
Expectations of future profit
Real interest rate: lower rates means higher value equity and more economic activity.
Perceptions of risk
Real growth
Inflation
Currency: Weak domestic currency is generally good
for equity market
Supply – privatisations, share buybacks
Investors change with change in regulatory regime, tax regime or liability profile.
Political climate
Overseas equity markets
Alternative investments
79
Explain the PE ratio
Number of years for earnings to buy themselves
Higher the PE ratio the more expensive the market is
Low interest rate mean high prices as discounting at lower rate
80
What's the effect of the dollar weakening for your portfolio
This weakening of the dollar is bad for you if you’re unhedged, other things being equal. Tendency is for prices to go up. Oil would appreciate for example.
81
Why invest overseas?
Achieve the full benefits of diversification - lower correlation with domestic assets different economic cycle, industry, firms
To increase returns however, risk must be defined relative to the liabilities
Through currency hedging, the taking of currency risk with exposure to foreign securities is largely optional
82
Problems investing overseas
Need expertise in the market as you have less information - costly
Different accounting practices
Language problems
Time delays
Poor regulation
Higher political risks
Liquidity problems
Less well-regulated
Politically unstable, and quite volatile
Market oscillates between fear and greed.
83
What factors should be considered before investing in foreign emerging markets
Current market valuation (relative to my own)
Outlook for currency - stability and strength.
Range of industries/companies
Level of marketability
Quality of information and regulation.
Economic outlook
Political stability
84
How to gain exposure to overseas securities?
Directly - buy a security, higher set up and overhead costs so perhaps for larger fund management firm.
Indirectly:
Buy multinationals listed in the domestic market:
Buy domestic company with high export trade
Buy a derivative
Buy an index-tracking fund or exchange traded fund
Buy into a specialist investment company
Buy into a specialist unit trust
85
Whats the effect of short term interest rates falling on government bonds
The yields on short term bonds are related to returns on money market instruments so a reduction in short term interest rates will boost prices of short bonds.
As yield falls, price increases
Investors in long bonds may interpret a cut in interest rates as a sign of monetary easing, with potentially inflationary consequences so yield on long bonds might decline by a smaller amount, or even rise
Lower exchange rate will affect the demand from overseas investors.- increases the price of bonds.
Index-linked bonds will be increase the relative attraction of these bonds and so should
increase the price
86
What additional effect would reducing short term interest rates have on corporate bonds different to government bonds
If the change in interest rates is viewed as likely to lead to economic growth then this should increase corporate profitability and so reduce the risks of corporate bonds relative to government bonds. This should reduce the yield margin. The margin will also be influenced by the availability and price of government bonds
87
Define a credit rating
A credit rating is given to a company’s debt by a credit rating agency as an indication of the likelihood of default/credit loss
88
How to reduce credit risk of corporate bonds
Ensure high quality and nature of bonds is appropriate to the fund.
Monitoring
Company reputation
Are there sector concerns
Not all exposure to any single bond or counterparty or sector?
Are there any risks due to the country, currency, environment, resource or technology?
Ethical issues? - affect marketability
Amount of debt finance being used - how much prior ranking debt do they have.
Can the debt be serviced and repaid? How safe is the source of payment
Income and capital cover
Security - enhances lenders position
Credit rating
Floating charge over all or some assets of company
Term of investment - Shortening
Insurance? Credit default swaps
89
What are the limitations of credit ratings
Time point: conditions may change ratings may not be adjusted quickly.
Consider circumstances of the company as well as rating
Other information useful, probability of default?
Agency may be too close to the company management
Credit rating agency may make error of judgement or not have complete information
Doesn’t measure the severity very well.
90
Differences in government vs corporate bonds yields
marketability / liquidity
supply and demand
credit quality (of particular issue)
corporate prospects (of issuing company)
forecast strength of economy
tax and restrictions on investors
different terms
91
Why are corporate bonds suitable for those providing retiree benefits?
The fixed in monetary terms of corporate debt is suitable to match liabilities
Maturing schemes - with bonds liabilities can be matched
Decision will be influenced by: Supply of government debt, corporate debt in the area, terms available, relative supply of bonds and equity as the equity supply affects bond prices
Diversification ebenfits: higher yield cause of credit risk, reduced liquidity and scope for active management
Tax considerations - Corporate can be taxed CGT and income.F
92
Why do investor preferences change
a change in their liabilities
a change in the regulatory or tax regimes
uncertainty in the political climate
fashion or sentiment altering
sometimes for no discernible reason
marketing
investor education undertaken by the suppliers of a particular asset class
a change in the asset valuations
a change in their risk appetite
change in wealth/personal status
availability of new investment products
93
How can a bond fund enhance return
Active trading, with better anticipation of how the macro-economic factors determining yield will play out.
By exploiting my unique tax position – only net return matters.
Exploiting my position if I do not need liquidity- illiquidity premium.
By exploiting credit risk
94
You are of the view that inflation is likely to increase faster than the market anticipates. What do you do with bonds?
Shorten the duration of the fund, relative to its benchmark. So when inflation is seen to increase and nominal yields rise, I will suffer less of a capital loss than the benchmark.
I would sell nominal stock and buy index-linked stock which protects me against rises in
inflation.
95
What to consider when making a loan?
Do they have the cash to loan?
Is the loan appropriate to the fund’s investment objectives?
The rate of return comparison
Existing capital structure of the company.
Will debt will be secured on specific assets.
Is debt subordinate to other debt.
The purpose of the loan
Tax treatment of loan
Any regulatory issues around loan
Any ethical issues?
Marketability of the loan.
Existing holdings of corporate debt, will this cause concentration of risk.
Term of the loan matches the liabilities of the fund.
Whether fixed repayments match the liabilities is inflation-proofing is required.
Cost of administering debt - are consultants knowledge needed?
A detailed analysis of the person paying loan back such as financial statements, and also: Business plans, Management/ character of the company, Product, Outlook for the sector and the market, Competitive position
Could terms be negotiated better.
96
Why are there differences in returns for equity vs bonds
Bonds are lower risk so lower return
equity risk premium - i.e. is the additional return that investors require for risks relative to risk free return
Equity risk premium fluctuates depending on confidence of investors and their risk outlook
Different level of inflation expectations
Equities are more volatile so higher required return
Tax implications are different
Dividend expectations could be higher ex: economic growth expected
Greater default risk
Bonds passive equities active management
Time horizon can differ
97
Define systematic and diversifiable risks
Systematic risk is risk that affects an entire financial market or system - cannot avoid through diversification
Diversifiable risk arises from an individual component of a financial market or system.
98
What is main systematic risk in equity fund
The main systematic risk in the fund is a decline in the domestic equity market, with all stocks being affected
99
How can diversifiable risk be mitigated
By investing in many holdings, by industry, by idnividual stocks- want to limit exposure to only systematic risk
The fund manager could purchase options to ensure their actual
return does not deviate too far away, although that could be expensive and reduce returns
100
What are the stakeholders affected in the Risk management process for an investment fund
Business units will often have a risk manager responsible for using the allocated risk budget effectively
All employees- report risks and come up with way to control
Auditors monitoring risk and adhering to management policies
Risk committee
Must have processes in place for employees to easily report risks which CRO can respond to
Fund manager - stay within risk budget
Accountability of who is going to monitor against agreed risk target and budget.
CRO
101
What is role of the CRO
A CRO’s role is to have responsibility for overall leadership and development of risk management within the organization. The CRO will give advice to the Board on risk
102
What are ethical investment funds and common criteria for them
Ethical investment funds are products that have a ‘socially responsible overlay’ to the selection criteria for investments and the investment managers commit to engaging in a
constructive dialogue with company management to promote environmental and ethical objectives
Criteria: Corporate governance, directors remuneration, ownership structures, environmental issues, business model, sector, working conditions/pay. diversity, geography and political regime.
103
Discuss whether ethical investment funds have lower expected returns than other investment funds
Higher risk funds - higher expected returns but maybe more volatile, with returns lower than less volatile funds.
High risk=high reward & deep troughs
Ethical criteria exclude certain sectors - very small part of the economy, won't impact fund performance.
Ethical criteria exclude those with poor corporate governance, taking higher ethical risks, should avoid anyways.
Investment meeting ethical criteria: high demand, price and lower returns. However, balance with lower volatility and lower risk.
Will be opportunities high risk high reward in future for ethical investment ex: tech
Costs more to run firm ethically - lower profit and return
Longer term may be increased requirements by the government. Ethical business will flourish and other businesses struggle with costs.
104
How can firm mitigate risks to brand and profitability investing in ethical investment funds
Brand should not rely on fund performance
Increasing demand for ethical funds - change in attitude
Company need to sell these
Firms need high ethical standards - corporate governance, diversity.
Firm needs to make better and less risky decisions
better at managing risks and produce better investment returns
Changing products to have ethical investment - have the demand - will boost profitability
Firm itself needs ethical standards high - develop ethical side of brand
Explain to customers the importance of ethical criteria for good long term performance.
Counter perception of ethical investment means lower returns
Work with competitors and regulators to encourage new rules.
