Risk

Question 1

Calculate holding period return

Answer 1

HPR = [ending value – beginning value] / beginning value

Question 2

Calculate Covariance using correlation

Answer 2

COV AB = P x (SD1 x SD2)

Question 3

Use a financial calculator to compute money weighted return

Question 4

Calculate Beta

Answer 4

beta = covariance / market variance

Question 5

LOS 64.e: Describe the investment constraints of liquidity, time horizon, tax concerns, legal and regulatory factors, and unique circumstances and their implications for the choice of portfolio assets.

Answer 5

RR TT LL U

Question 6

Define a cognitive error

Answer 6

are due primarily to faulty reasoning or irrationality. They can arise from not understanding statistical analysis, information processing errors, illogical reasoning, or memory errors. Such errors can possibly be reduced by increased awareness, better training, or more information.

Cognitive errors can be divided into belief perseverance biases that reflect an irrational reluctance to change prior conclusions and decisions, and processing errors where the information analysis is flawed.

Question 7

Define emotional bias

Answer 7

are not related to conscious thought. Rather, they stem from feelings, impulses, or intuition. As such, they are difficult to overcome and may have to be accommodated.

Question 8

Conservatism bias (belief perseverance) Define?

Answer 8

occurs when market participants rationally form an initial view but then fail to change that view as new information becomes available. That is, they overweight their prior probabilities and do not adjust them appropriately as new information becomes available. Individuals displaying this bias tend to maintain prior forecasts and securities allocations, ignoring or failing to recognize the significance of new information. Individuals may react slowly to new data or ignore information that is complex to process.

Question 9

Confirmation bias

Answer 9

occurs when market participants focus on or seek information that supports prior beliefs, while avoiding or diminishing the importance of conflicting information or viewpoints. They may distort new information in a way that remains consistent with their prior beliefs.

Question 10

Representativeness bias …?

What are the two types?

Answer 10

occurs when certain characteristics are used to put an investment in a category and the individual concludes that it will have the characteristics of investments in that category. Individuals systematically make the error of believing that two things that are similar in some respects are more similar in other respects than they actually are.

Base rate neglect

refers to analyzing an individual member of a population without adequately considering the probability of a characteristic in that population (the base rate). Consider this example of base-rate neglect: a group was asked to identify the most likely occupation of a man who was characterized as somewhat shy as a salesperson or a librarian. Most participants chose librarian, thinking that most librarians would tend to be more shy on average than salespeople, who tend to be outgoing. Their mistake was in not considering that there are relatively few male librarians and a great number of male salespeople. Even though a greater percentage of librarians may be characterized as somewhat shy, the absolute number of salespeople who could be characterized as somewhat shy is significantly greater.

Sample size neglect
refers to making a classification based on a small and potentially unrealistic data sample. The error is believing the population reflects the characteristics of the small sample.

Question 11

Illusion of control bias

Answer 11

exists when market participants believe they can control or affect outcomes when they cannot. It is often associated with emotional biases: illusion of knowledge (belief you know things you do not know), self-attribution (belief you personally caused something to happen), and overconfidence (an unwarranted belief that your beliefs will prove to be correct)

Question 12

Hindsight bias 

Answer 12

  is a selective memory of past events, actions, or what was knowable in the past, resulting in an individual’s tendency to see things as more predictable than they really are. People tend to remember their correct predictions and forget their incorrect ones. They also overestimate what could have been known. This behavior results from individuals being able to observe outcomes that did occur but not the outcomes that did not materialize. Hindsight bias is sometimes referred to as the I-knew-it-all-along phenomenon.

Hindsight bias is caused by three types of errors:

Individuals distort their earlier predictions when looking back. This is the tendency to believe that we knew the outcome of an uncertain event all along.
Individuals tend to view events that have occurred as inevitable.
Individuals assume they could have foreseen the outcomes of uncertain events.

Question 13

Cognitive Errors: Information-Processing Biases

Answer 13

These are related more to the processing of information and less to the decision-making process.

Question 14

Anchoring and adjustment bias

Answer 14

refers to basing expectations on a prior number and overweighting its importance, making adjustments in relation to that number as new information arrives. Examples would be estimating the value of a security relative to its current value or making estimates of earnings per share relative to a previously reported value or relative to a prior estimate. Anchoring leads to underestimating the implications of new information. New data should be considered objectively without regard to any initial anchor point.

Question 15

Mental accounting bias

Answer 15

refers to viewing money in different accounts or from different sources differently when making investment decisions. This conflicts with the idea that security decisions should be made in the context of the investor’s overall portfolio of assets based on their financial goals and risk tolerance.

Question 16

Framing bias

Answer 16

occurs when decisions are affected by the way in which the question or data is “framed.” In other words, the way a question is phrased can influence the answer given. Tversky and Kahneman (1980)2 illustrate framing bias with the following example.

EXAMPLE: Framing bias (framing as a gain)

The United States is preparing for the outbreak of an unusual disease, which is expected to kill 600 people. Two alternative programs have been proposed. If Program A is adopted, 200 people will be saved. If Program B is adopted, there is a one-third probability that 600 people will be saved and a two-thirds probability that no one will be saved. Which program will people choose

Question 17

Availability bias

Answer 17

refers to putting undue emphasis on information that is readily available, easy to recall, or based narrowly on personal experience or knowledge. Availability bias occurs when individuals judge the probability of an event occurring by the ease with which examples and instances come to mind. By the very nature of memory, more-recent events are typically easier to recall than events further in the past, which leads to the bias of attaching too much significance to events that have occurred recently and too little to events that occurred further in the past. People also tend to assume that if something is easily remembered, it must occur with a higher probability

Question 18

Difference between emotional and cognitive bias

Answer 18

In general, if an investor’s view is based on unconscious emotion that the holder is unwilling or unable to change, we should regard it as an emotional bias. If a bias can be overcome with a relatively simple change in thought process or information, we should regard it as a cognitive bias.

Question 19

Loss-aversion bias

Answer 19

arises from feeling more pain from a loss than pleasure from an equal gain. Kahneman and Tversky (1979)1 investigated differences between how people feel when they gain and when they lose and how that affects behavior when faced with risk. They found that individuals’ willingness to take a gamble (risk) was very different when facing a loss or a gain.

Be sure to understand the difference between risk aversion and loss aversion. A risk-averse investor is simply an investor who, given two investments with the same expected returns, would select the investment with the lowest risk. A loss-averse investor is one who feels greater pain (decreases in utility) from losses than satisfaction (increase in utility) from gains. As a result, the individual is more likely to take a risk in the hope of avoiding losses than in the hope of achieving gains.

Question 20

Overconfidence bias

Answer 20

occurs when market participants overestimate their own intuitive ability or reasoning. It can show up as illusion of knowledge when they think they do a better job of predicting than they actually do. Combined with self-attribution bias, individuals may give themselves personal credit when things go right (self-enhancing) but blame others or circumstances when things go wrong (self-protecting). Prediction overconfidence leads individuals to underestimate uncertainty and the standard deviation of their predictions, while certainty overconfidence occurs when they overstate the probability they will be right.

While overconfidence is both cognitive and emotional, it is more emotional in nature because it is difficult for most individuals to correct and is rooted in the desire to feel good. Overconfidence bias may cause market participants to underestimate risk, overestimate return, and fail to diversify sufficiently.

Question 21

Overconfidence bias

Answer 21

occurs when market participants overestimate their own intuitive ability or reasoning. It can show up as illusion of knowledge when they think they do a better job of predicting than they actually do. Combined with self-attribution bias, individuals may give themselves personal credit when things go right (self-enhancing) but blame others or circumstances when things go wrong (self-protecting). Prediction overconfidence leads individuals to underestimate uncertainty and the standard deviation of their predictions, while certainty overconfidence occurs when they overstate the probability they will be right.

While overconfidence is both cognitive and emotional, it is more emotional in nature because it is difficult for most individuals to correct and is rooted in the desire to feel good. Overconfidence bias may cause market participants to underestimate risk, overestimate return, and fail to diversify sufficiently.

Question 22

Self-control bias

Answer 22

occurs when individuals lack self-discipline and favor short-term satisfaction over long-term goals. Often, individuals are not prepared to make short-term sacrifices to meet their long-term goals. They may favor small payoffs now at the expense of larger payoffs in the future, which is known as hyperbolic discounting.

Self-control bias may result in insufficient savings to fund retirement needs, which in turn may cause an investor to take excessive risk to try to compensate for insufficient savings accumulation. It may also result in overemphasis on income-producing assets to meet short-term needs.

Self-control bias might be mitigated by establishing an appropriate investment plan (asset allocation) and a budget to achieve sufficient savings. Both should be reviewed on a regular basis.

Question 23

Status quo bias

Answer 23

occurs when comfort with an existing situation causes an individual to be resistant to change. If investment choices include the option to maintain existing investments or allocations, or if a choice will happen unless the participant opts out, status quo choices become more likely.

Companies have found that automatically enrolling workers in retirement savings schemes, with the option to opt out, increases participation compared with making it necessary for employees to opt in. Thaler and Sunstein (2008)2 argue for framing choices in this way to achieve better participation rates in retirement plans, as well as other choices, such as whether to register as an organ donor.

Consequences of status quo bias may include holding portfolios with inappropriate risk and not considering other, better investment alternatives.

Question 24

Endowment bias

Answer 24

Endowment bias occurs when an asset is felt to be special and more valuable simply because it is already owned. For example, a spouse may hold on to securities the deceased spouse purchased, for reasons like sentiment that are unrelated to the current merits of the securities. Endowment bias is common with inherited assets and might be detected or mitigated by asking a question such as “Would you make this same investment with new money today?”

Question 25

Regret-aversion bias

Answer 25

Regret-aversion bias occurs when market participants do nothing out of excessive fear that actions could be wrong. They attach undue weight to errors of commission (doing something that turns out wrong) and not enough weight to errors of omission (not doing something that would have turned out right). Their sense of regret and pain is stronger for acts of commission. This is quite similar to status quo bias.

Herding behavior is a form of regret - aversion where participants go with the consensus or popular opinion. Essentially, participants tell themselves they are not to blame if others are wrong too.

Question 26

The halo effect suggests that investors tend to overvalue stocks:

Answer 26

The halo effect suggests investors will view a stock that has experienced rapid growth and price appreciation as a good stock to own, which may result in these stocks being overvalued. Home bias is the tendency for investors to favor stocks from their own country or region because they are more familiar with those stocks. (Module 65.2, LOS 65.c)

Question 27

Define risk management.

Answer 27

Risk management is the process of identifying and measuring the risks an organization (or portfolio manager or individual) faces, determining an acceptable level of overall risk (establishing risk tolerance), deciding which risks should be taken and which risks should be reduced or avoided, and putting the structure in place to maintain the bundle of risks that is expected to best achieve the goals of the organization.

Question 28

Describe features of a risk management framework.

Answer 28

-Establishing processes and policies for risk governance.
-Determining the organization’s risk tolerance.
-Identifying and measuring existing risks.
-Managing and mitigating risks to achieve the optimal bundle of risks.
-Monitoring risk exposures over time.
-Communicating across the organization.
-Performing strategic risk analysis.

Question 29

Derivatives risks

Delta
Gamma
Vega
Rho

Answer 29

Delta. This is the sensitivity of derivatives values to the price of the underlying asset.

Gamma. This is the sensitivity of delta to changes in the price of the underlying asset.

Vega. This is the sensitivity of derivatives values to the volatility of the price of the underlying asset.

Rho. This is the sensitivity of derivatives values to changes in the risk-free rate.

Question 30

Value at risk (VaR)

Answer 30

is the minimum loss over a period that will occur with a specific probability

Question 31

Conditional VaR (CVaR)

Answer 31

is the expected value of a loss, given that the loss exceeds a minimum amount. Relating this to the VaR measure presented previously, the CVaR would be the expected loss, given that the loss was at least $1 million. It is calculated as the probability-weighted average loss for all losses expected to be at least $1 million. CVaR is similar to the measure of loss given default that is used in estimating risk for debt securities.

Question 32

Stress testing

Answer 32

examines the effects of a specific (usually extreme) change in a key variable such as an interest rate or exchange rate.

Question 33

Scenario analysis

Answer 33

refers to a similar what-if analysis of expected loss but incorporates changes in multiple inputs. A given scenario might combine an interest rate change with a significant change in oil prices or exchange rates.

Question 34

What is tail risk?

Answer 34

the probability of or magnitude of extreme negative outcomes in the tail of a distribution

Question 35

Difference between shifting and transferring a risk

Answer 35

Risk transfer is commonly confused with risk shifting. To reiterate, risk transfer is passing on (“transferring”) risk to a third party. On the other hand, risk shifting involves changing (“shifting”) the distribution of risky outcomes rather than passing on the risk to a third party.