Topic 2 - How is risk related to return

Question 1

What is Relative Value?

Answer 1

Gives the value of the portfolio some context, such as a real growth rate of 1% or a compounded growth rate of 1.4%.

Question 2

What is the difference between RPI & CPI?

Answer 2

RPI includes cost of housing e.g mortgage interest & council tax. Typically affects working population with liabilities. RPI is a weighted average so usually higher than CPI.

CPI typically effects retirees who don’t have mortgages, life or health assurance premiums. CPI is a geometric average so is usually lower than RPI.

Basket of goods that comprises each inflation rate is not applicable to everyone.

Example of Inflation:

Dan buys £100k home using 10% (£10k deposit). House appreciates to £110k so he has doubled his investment should he have to sell. However house depreciates to £90k then Dan has lost 100% of investment if he sells.

Question 3

What is the difference between nominal/absolute and real/relative returns?

What are the effects if the real return becomes negative?

What are the FCA inflation assumptions?

Answer 3

Nominal/Absolute - Doesn’t take account of inflation. Real/Relative Return - Does.

When real return is negative it:

• Creates doubt - firms defer investment and individuals defer spending
• Time & effort spent guarding against inflation rather than trying to fulfill client objective.
• Internationally exported goods/services become less competitive

FCA Projection Assumptions

• Cap nominal intermediate rate of return for tax-exempt business at 5%. Other products at 4.5%
• Base assumption on CPI rather than RPI to reduce rate from 2.5% to 2%.

Question 4

What are money market securities?

When they are used and most suitable and when are they not?

Answer 4

• Allows financing for short-term cash requirements
• Preserves nominal value of amount invested
• Important in times of volatility or uncertainty
• Normally unsuitable for long term - 5 years or more

Question 5

How do you calculate the Real Rate of Return?

What method can you use to make the Real Return more Accurate and how do you calculate this?

Answer 5

• Nominal return minus revailing inflation rate
• Not entirely accurate. Use Fischer Real Return
• 1 + R = (1 + r) divided by (1 + i)
  
  • R = Real Return
  • r = Nominal Rate of Interest
  • i = Prevailing Rate of Inflation
  • Remember to use interest and inflation for same time period (monthly, yearly etc
• Example - Nominal Rate 1.15%. Inflation 2.5%
• 1+1.15% = 1.0115
• 1+2.5% = 1.025
• 1.0115 / 1.025 = 0.9868292
• 0.9868292 - 1 = 0.0131708 x 100 = 1.317%.

Question 6

What is Effective Interest Rate/Annual Equivalent Rate?

How do you calculate it?

Answer 6

Nominal Rate doesn’t take in account affect of compounding if interest is paid more frequently than annual.

The more compounding periods during year, the higher the effective interest rate/

Effective Interest Rate = (1 + nominal rate e.g 0.15 for 15% divided by the amount of compounding periods throughout year) x to the power of compounding periods - 1

Compounding over different periods. Replace the 12 with the number of times it is compounded over period.

Question 7

What is the difference between Simple and Compound Interest?

Answer 7

Simple interest

The addition of interest to the original principal amount.

Compound interest

Interest accumulated on the original principal amount plus on earned interest

Question 8

What are BRIC Markets?

What are the advantages & disadvantages of investing in BRICs?

Answer 8

BRICs = Emerging Markets. Brazil. Russia. India. China. (Potentially also Africa)

Advantages

Potential for higher returns above domestic economy. Developed western economies are strongly correlated to each other so provides another level of diversification.

Disadvantages

• Risk levels may be too high
• Legal limitation on foreign investment by developing markets which affect supply/demand
• Central government may be big sharehilder which limits commercial objectives of firm
• Regulations of country may limit amount of fund movement or may not have robust regulatory system to tackle insider trading or corruption
• Taxation at different times and rates may result in end return not worth extra risk
• Currency fluctuation risk
• Political Risk - Corruption, UN Sanctions can cause inefficiency or markets to freeze.
• Poor liquidity and high transaction costs may restrict flexibility compared to developed markets