Risk Based Questions Flashcards
Understand Risks taken
With regard to Tom and Sally’s investment portfolio, excluding their main
residence,
(a) identify and briefly describe eight types of investment risk they may face (8)
nflation risk – that spending power of an asset will be eroded
Market or systematic risk – the stock market value may fall
Default/provider risk – investment provider may not be able to pay or credit risk –
debtors may not pay
Taxation risk – legislation may affect tax treatment of investments
Diversification risk – too much exposure to any one type of asset class, one provider
or one investment
Interest risk - the risk that falls in rates could reduce the interest on savings. Rises in
rates could impact of fixed interest yields.
Event risk - specific event e.g. earthquake/tsunami, can affect performance
Currency risk – non-sterling assets may suffer by exchange rate movements
how the risks identified apply to Tom and Sally’s situation INFLATION RISK (2)
They have approximately 12% of their investable assets
in cash-based assets. While this not a high %, it is a large
sum of money, so they have a significant degree of
exposure in this area
Their exposure to market risk is high – they have
approximately 80% of their investable assets in equity
based or corporate investments
how the risks identified apply to Tom and Sally’s situation Currency risk (1)
They have global equity funds
how the risks identified apply to Tom and Sally’s situation Event risk (1)
The equity investments could be subject to event risk
They have exposure to equity-based funds.
how the risks identified apply to Tom and Sally’s situation Interest risk(1)
They currently hold a significant amount of funds in
cash-based assets and therefore have exposure in this
area, and the £40,000 in the joint deposit account is
yielding 1%, which is low for such a sum.
how the risks identified apply to Tom and Sally’s situation Diversification risk/lack of diversification (3)
They currently hold 12% of their assets in cash
Of Tom’s solely owned investments, 57% are equity based
For Sally the figure is 83%, which is high even for her adventurous attitude to risk
33% of Tom’s solely owned investments are in
corporate bonds, which while not incompatible with
his attitude to risk, but this depends on the
companies invested in and the objectives of the
funds
They have no exposure to any form of property
investment apart from their home, although they
wish to address this
Their large exposure to cash does not match their
adventurous attitude to risk.
The geographical spread also needs to be considered
how the risks identified apply to Tom and Sally’s situation Taxation risk (2)
The taxation treatment of ISAs may change.
The tax treatment on the investment types held may
change/be subject to legislative changes
how the risks identified apply to Tom and Sally’s situation Default/provider risk (4)
Under the FSCS they would be protected for £85,000 per
person per banking license for their cash holdings.
They hold £98,000 jointly in Securebank, so fully
protected
It is not known about the number of providers are being
used for their ISAs or Tom’s unit trusts - they are only
protected for £50,000 under the FSCS per person per
institution
Describe the process of using a risk-profiling tool (8)
Tom and Sally would complete a questionnaire
• This focuses on their timescale, priorities, circumstances and preferences
• The answers are fed into an approved computer program
• It generates a score to reflect their appetite for risk
• and produces a recommended asset model using the risk score
• Often using the efficient frontier for investments
• The results would then be discussed with the clients
• to ensure that the results match their perception of their risk profile
Describe Psychometric Risk Profiling (10)
Aim of psychometric risk profiling is to
assess the client’s psychological risk
tolerance or preference, rather than their
objective financial capacity to take risks
Input is a usually an online questionnaire of
around 25 questions
Output is an instant report setting out the
client’s views about risk-based decisions
Questions typically ask the clients to rate
themselves on:
o how they assess themselves for risk
tolerance
o the history of their behaviour with
regard to financial decision making
o their intended financial behaviour in
the future
o how they might behave in a range of
different realistic financial scenarios
o their emotional responses to various
financial possible events and outcomes
Responses to these questions generates a
risk score that typically compares the
client’s risk tolerance other investors
worldwide
Describe Stochastic Modelling (9)
Aim of stochastic models is to predict probable outcomes for different investments depending on a range of assumptions in an uncertain world Stochastic means having a chance or random element Aim is to help explain investment risk to the client, compare alternative strategies, recommend a portfolio of suitable investments and then monitor and review their subsequent progress Stochastic model forecasts a range of possible returns from different portfolios of investments Model produces projection of the most likely income returns from different asset mixes Model also produces a pictorial illustration of the range of less probable outcomes that might happen Model makes predictions about the future Assumptions on which the predictions are based are reasonable and are updated frequently to take account of recent developments, but the assumptions may turn out to be wrong The assumptions should therefore be conservative, consistent and realistic
