Risk and Reward Flashcards

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1
Q

What factors influence returns? (3)

A

How the economy performs

What events are taking place in the investment’s geographical location

how the sector in which the company operates behaves

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2
Q

How is overall ER calculated?

A

Expected returns = probability x scenario return and summing the results

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3
Q

What is variance?

A

Variance is the extent to which returns vary from the average or expected return

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4
Q

What is standard deviation?

A

The square root of variance which is used as a statistical measure of risk to depict likely variance from ER

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5
Q

Types of risk at macro level (2)

A

Market crashes

Terrorism that cause markets to plunge

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6
Q

Types of risk at micro level (2)

A

Creditworthiness or company invested in

Internal events of company invested in

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7
Q

General types of risk (8)

A

Market risk

Political and legal risk

Reinvestment risk

Inflation risk

Interest rate risk

Exchange rate risk

Liquidity risk

Default risk

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8
Q

Ways of quantifying risk (2)

A

Forward looking where forecasts and probabilities assess likelihood of possible states of the world and predict each possible outcome

Backward looking where analysis on historically observed returns and associated frequencies on the basis that past data is representative of future data

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9
Q

Levels of risk attached to types of equity (2)

A

Medium levels of risk are attached to larger, well-established company shares

High levels of risk are attached to startup company shares

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10
Q

What is an equity premium?

A

A higher rate of return offered to entice investors to take on the risk of owning shares or equity

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11
Q

What makes an Equity investment more risky? (2)

A

Non secured asset

Company can suffer from adverse business conditions even bankruptcy

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12
Q

What is the risk-free rate?

A

The rate on gvt bonds and short term debts because of low chance of default

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13
Q

Risks associated with money market instruments (2)

A

Prices can fluctuate

If investors want to swap with more secure issuers such as T-bills, discount priced instruments will yield negative returns

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14
Q

What factors are a trade off in money market instruments?

A

There is trade-off and calculation between the value of a long term income stream from money market instruments vs. greater volatility of longer dated paper

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15
Q

What makes bonds over equities attractive to investors? (3)

A

Offer fixed income

Regular, predetermined coupon

Certainty of principal being repaid at end of term

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16
Q

Main difference of investment risks in bonds vs. equity (4)

A

Bonds offer less risk but also less substantial returns

If bonds sold before maturity,market value may be less than nominal or par value

Interest rate rises may devalue investment on fixed rate bonds

When inflation is more than investor expected, value of bond investment may fall however equities cope well with unexpected inflation

17
Q

What risk criteria is applied by the three largest rating agencies to bonds? (3)

A

Reliability of the bond

payment history of the bond

the issuer’s current financial situation

18
Q

What are the two main categories of risk assigned by rating agencies?

A

Investment grade i.e. prime or non-investment grade i.e. junk

19
Q

What gradings signify investment grade investment? (2)

A

At least Baa from Moody’s or at least BBB from Fitch or S&P

20
Q

Effects of downgraded investment on Bond issuer

A

Potential investors will want to compensate by demanding greater yield which means lower bond price

Issuer may look to utilise credit enhancements such as guarantee by another group company or fixed charge over assets

21
Q

What is correlation?

A

Assets where there is a low or high degree of association between the price movements and return on investment

22
Q

How can the degree of correlation be expressed?

A

How much directional changes in each asset’s returns or co-movement are associated i.e. if asset A and asset B tend to react to the same kinds of conditions, they will be strongly correlated.

23
Q

What is diversification?

A

Holding investments with uncorrelated returns by not being perfectly positively correlated although they can still be of similar nature.

24
Q

How can you diversify by asset class?

A

By holding a combination of cash, fixed-interest securities, equity and property based investments

25
Q

What is bond switching?

A

A method used by active portfolio managers by exchanging bonds perceived as overpriced for those that appear to be under-priced.

26
Q

Types of bond switching (3)

A
  1. Anomaly Switching
  2. Policy Switching
  3. Inter-market Spread Switch
27
Q

What is anomaly switching?

A

Moving from highly to lower priced bonds which are similar except for their yield and price

28
Q

What is policy switching?

A

Selling shorter dated bonds for longer dated bonds when an interest rate cut is expected but not implied by the yield curve

29
Q

What is inter-market spread switch?

A

When a difference in yield is excessive given the perceived risk of an instrument and a manager sells in favour of the lower yield

30
Q

What is an immunised bond portfolio?

A

A portfolio that is insulated from the effects of future interest rate changes when a passive investment manager knows they have a future liability to meet

31
Q

What is the Efficient Market Hypothesis?

A

It’s impossible to beat market as stock market efficiency always presents fair value of shares by taking in all relevant information

32
Q

What is a hedge fund?

A

Unauthorised investment vehicles domiciled in a tax efficient jurisdiction that is free to invest in high-risk strategies e.g. arbitrage and highly geared derivatives

33
Q

What is RNS?

A

LSE’s Regulatory News Service used to notify market of any changes

34
Q

What is a PIP?

A

Primary information providers which receives regulatory information from listed companies

35
Q

What is a SIP and examples? (3)

A

Examples are Bloomberg, Reuters and Dow Jones

Secondary Information Providers that receive info from PIPs and disseminate to stockbrokers, research analysts and wider financial community