Risk and Reward Flashcards
What factors influence returns? (3)
How the economy performs
What events are taking place in the investment’s geographical location
how the sector in which the company operates behaves
How is overall ER calculated?
Expected returns = probability x scenario return and summing the results
What is variance?
Variance is the extent to which returns vary from the average or expected return
What is standard deviation?
The square root of variance which is used as a statistical measure of risk to depict likely variance from ER
Types of risk at macro level (2)
Market crashes
Terrorism that cause markets to plunge
Types of risk at micro level (2)
Creditworthiness or company invested in
Internal events of company invested in
General types of risk (8)
Market risk
Political and legal risk
Reinvestment risk
Inflation risk
Interest rate risk
Exchange rate risk
Liquidity risk
Default risk
Ways of quantifying risk (2)
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
Levels of risk attached to types of equity (2)
Medium levels of risk are attached to larger, well-established company shares
High levels of risk are attached to startup company shares
What is an equity premium?
A higher rate of return offered to entice investors to take on the risk of owning shares or equity
What makes an Equity investment more risky? (2)
Non secured asset
Company can suffer from adverse business conditions even bankruptcy
What is the risk-free rate?
The rate on gvt bonds and short term debts because of low chance of default
Risks associated with money market instruments (2)
Prices can fluctuate
If investors want to swap with more secure issuers such as T-bills, discount priced instruments will yield negative returns
What factors are a trade off in money market instruments?
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
What makes bonds over equities attractive to investors? (3)
Offer fixed income
Regular, predetermined coupon
Certainty of principal being repaid at end of term
Main difference of investment risks in bonds vs. equity (4)
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
What risk criteria is applied by the three largest rating agencies to bonds? (3)
Reliability of the bond
payment history of the bond
the issuer’s current financial situation
What are the two main categories of risk assigned by rating agencies?
Investment grade i.e. prime or non-investment grade i.e. junk
What gradings signify investment grade investment? (2)
At least Baa from Moody’s or at least BBB from Fitch or S&P
Effects of downgraded investment on Bond issuer
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
What is correlation?
Assets where there is a low or high degree of association between the price movements and return on investment
How can the degree of correlation be expressed?
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.
What is diversification?
Holding investments with uncorrelated returns by not being perfectly positively correlated although they can still be of similar nature.
How can you diversify by asset class?
By holding a combination of cash, fixed-interest securities, equity and property based investments
