Section 1 Flashcards
what are criticisms of standard deviation as an indicator of risk?
- it is based on patterns of returns, which may not be representative of future patterns in returns
- it is a measure of upside movements as well as downside movements. In investment management the concern may generally be about the downside alone
- it assumes that upside is equally as likely as downside - the standard deviation, by definition, is the average upside or downside movement
- volatility generally is not a complete measure of risk. For example inflation risk may affect non-growth assets
explain relationship between risk and return
the return achievable is directly affected by the degree of risk taken: the greater level of risk, the greater the potential return
what is a dominant investment strategy
an investment strategy that has a higher expected return than another strategy, but the same or lower level of risk is said to be ‘dominant’
what is semi-variance as a measure of risk
only measures returns over a period that fall below average (mean). This means that it is a downside measure of risk. Focusing on client’s concern of achieving below-average return
what is probability of shortfall as a measure of risk?
is a measure of risk that identifies the chance of a return over a specific period falling below a target level. It only measures chance, and does not give the value of the shortfall
what is expected shortfall as a measure of risk
is a measure of expected loss at a given probability level
what is drawdown as a measure of risk?
Is the decline in price from a historical peak value of an investment
it measures the maximum amount which an investor could have lost since the investment was at its highest price
what are advantages of drawdown as a measure of risk?
- it refers to an empirical reality and is therefore less abstract than other measures
what are the limitations of drawdown as a measure of risk?
- for most investible time series longevity implies survival and robustness, but a longer track record implies a larger worse drawdown
- Maximum drawdown is a single number and will therefore ave a large and uncertain error distribution
- Cant be sure that a time series with a longer track record implies that a larger worse drawdown is more likely.
what is tracking error as a measure of risk?
the difference between a portfolio’s return and the benchmark or index it was meant to follow
what are advantages of using tracking error as a measure of risk?
Approach is useful where there are more periods of time over which to measure performance
what does a low tracking error mean
the portfolio is closely following its benchmark and high indicates the opposite
what is total risk made up of?
Total risk = systematic risk + unsystematic risk
what is systematic risk?
• Non-specific – systematic o aka. Market risk o Measured by Beta o Identify risk and try to maximise risk and return relationship o Can’t be reduced o Present in multiple assets
what is unsystematic risk
• Specific (e.g. loss of a contract) / Idiosyncratic / Unique / Unsystematic
o Will try to diversify away the above risks. Basic idea is that you just have more companies so specific risks won’t affect other companies
what would be perfect positive correlation?
+1
what would be perfect negative correlation?
-1
what would a correlation of 0 imply
no correlation
what are the shortfalls of correlation coefficients?
- when extreme market movements occur, correlations between asset converge to +1. In other words, correlations change over time - so an unexpected change in correlation can affect exposures designed to offset each other
- correlation is meaningless when the assets being considered do not follow a normal or ‘nearly normal’ distribution
- correlation only captures linear associations between assets; many more complicated products have non-linear association
- correlation does not imply causation - if two assets are highly correlated, this may be due to a brief transitionary common factor. Analysts always need to question the source of correlation to understand if it will persist
what is fraud risk?
intentional deception for gain or damage to another individual or organisation.
what is counterparty risk?
risk that a counterparty will not honour its obligations
what is inflation risk
impact of unanticipated changes in the level of prices in an economy on the ultimate purchasing power of an investment
what is currency risk
arises when the price of one currency changes in relation to another, and holders of assets denominated in foreign currencies will risk a fall in value when these are translated into domestic currency
what is interest rate risk
the variability in value of an interest-bearing asset or portfolio as interest rates change
