Risk and Return Flashcards
What is return on investment?
Return = amount received - amount invested
What is rate of return?
Rate of Return = return on investment / amount invested
What are two basic types of investment risk?
Systematic (market) risk and unsystematic (non-market or company) risk.
What is systematic risk?
It’s the risk faced by all firms (i.e. business cycle that affects all players in the market). This risk is sometimes referred to as undiversifiable risk because it can’t be offset by portfolio diversification.
What is unsystematic risk?
It’s the risk inherent in a particular investment security. This risk is determined by the issuer’s industry, products, customer loyalty, degree of leverage, management competence, etc. This risk is sometimes referred to as diversifiable risk because it can be offset by portfolio diversification.
List other types of investment risk (other than systematic and unsystematic risk).
Credit risk, foreign exchange risk, interest rate risk, political risk, liquidity risk, industry risk, purchasing power risk and financial risk.
What is credit risk?
The risk that issuer of a debt security will default.
What is liquidity risk?
The risk that a security can’t be sold on short notice for its market value.
What is industry risk?
The risk that a change will affect securities issued by firms in a particular industry.
What is purchasing power risk?
The risk that a general rise in price level will reduce the quantity of goods that can be purchased with a fixed amount of money.
How to know if expected return on an investment is sufficient to entice investors?
It depends on its risk, the risks and returns of alternative investments, and the investor’s attitude toward risk.
What are risk-averse investors?
They are usually serious investors and have diminishing marginal utility for wealth. Utility of a gain is less than the disutility of a loss of the same amount for those investors, so risky securities must have higher expected returns.
What are risk-neutral investors?
They adopt an expected value approach and have purely rational attitude toward risk. For those investors, utility of a gain equal to the disutility of a loss of the same amount.
What are risk-seeking investors?
They have optimistic attitude toward risk. For those investors, the utility of a gain exceeds the disutility of a loss of the same amount.
Explain the logic in risk ranking for securities.
Ranking is according to the level of security backing them. Secured securities are less risky than unsecured securities. Example from lowest risk/return to highest risk/return: US Treasury bonds, first mortgage bonds, second mortgage bonds, income bonds, preferred stock, convertible preferred stock, common stock.
