Risk

Question 1

Definition of Risk

Answer 1

– Possibility of loss or that something bad will happen
– Possibility that an expected outcome will not be achieved
– Mathematically risk can be expressed as the “probability of loss” x “the expected loss”

Question 2

Definition of Uncertainty

Answer 2

– Not having confidence in something
– Not knowing or being able to accurately predict future outcomes
– Sometimes uncertainty is defined in terms of risk metrics

Question 3

Types of Risk

Answer 3

loss of principal
purchasing power
liquidity
geopolitical
currency
sovereign
interest rate
credit
reinvestment 
shortfall
sequencing

Question 4

Formula for adjusting returns for currency changes

Answer 4

Adjusted return = (1 + return in local currency) x (1 + change in currency value) - 1

Question 5

Sovereign Risk

Answer 5

The risk that the central bank of a county will change activities, policy or regulations which will negatively impact trade, currency values or economic conditions, or that its government could even default on financial obligations.

Question 6

Credit Risk

Answer 6

The risk that a debtor will fail to meet his/her obligation to pay back a loan based on the terms of the agreement.

Differs from interest rate risk: Risk of decline in an investment’s value based on a change in interest rates

Question 7

Reinvestment Risk

Answer 7

Risk that an investor will have to reinvest the proceeds from an asset (bond) at a lower rate than originally invested.

Question 8

Shortfall Risk

Answer 8

The risk that funds (assets) or actual return will be lower than liabilities or expected return.

Question 9

Sequence Risk

Answer 9

This is the risk that the sequence of returns could negatively impact the wealth of the investor, especially during the distribution phase or when funds are needed.

Question 10

Risk terminology and investor types:
Fair game
Risk adverse investor
Risk neutral investor
Risk loving investor

Answer 10

• Fair Game : a risky investment with a risk premium of zero (i.e., a gamble)…
• Risk averse investor : rejects investments that offer “fair games” or worse; willing to consider risky investments only if return is above risk free return.
• Risk neutral investor : judges risky prospects solely by expected returns.
• Risk loving investor : happy to engage in fair games and gambles.