Topic 3 Investment Risk Management Flashcards
Types of investment risks
- Mismatch risk - the investment selection should meet the client’s needs
- Inflation risk/purchasing power risk
- Interest rate risk
- Market risk
- Currency risk
- Liquidity risk
- Credit risk/financial risk
- Legislative risk/tax risk
- Risk associated with inadequate diversification
- Tax risk
- Event risk
Was Julian’s strategy correct?
Julian aged 25, was given $40,000 from his grandfather’s estate. He wanted to use this money as a deposit for a house, but in the meantime he decided to invest the money.
‘I wanted to achieve a high return, so I’d have more money to use when I bought a house’, he said.
‘When I found a managed fund that earned 20% in the last months, and averaged over 15% a year over the past 3 years, I thought “Great – that’s perfect!”
Was Julian’s strategy correct?
Was Julian’s strategy correct?Julian aged 25, was given $40,000 from his grandfather’s estate. He wanted to use this money as a deposit for a house, but in the meantime he decided to invest the money.
‘I wanted to achieve a high return, so I’d have more money to use when I bought a house’, he said.
‘When I found a managed fund that earned 20% in the last months, and averaged over 15% a year over the past 3 years, I thought “Great – that’s perfect!”
Was Julian’s strategy correct?
Risk and return trade-off and diversification
- Risk is the ______ that an investment’s actual return will be different than expected
- Risk-return trade-off is the _________ between risk and return, in which investments with more risk should _________ higher returns, and vice versa
- Diversification is a risk management technique that _______ a wide variety of investments within a portfolio
- >the rationale of diversification is that a portfolio of different kinds of investments will, as a whole, yield higher returns and _______ a lower risk than any individual investment found within the portfolio
Risk and return trade-off and diversification
- Risk is the chance that an investment’s actual return will be different than expected
- Risk-return trade-off is the relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa
- Diversification is a risk management technique that mixes a wide variety of investments within a portfolio
- >the rationale of diversification is that a portfolio of different kinds of investments will, as a whole, yield higher returns and pose a lower risk than any individual investment found within the portfolio
Modern Portfolio Theory
- Modern Portfolio Theory (MPT) posits that it is possible to _______ maximum risk reduction by ___________ assets together in an optimal way
-> The amount of potential risk reduction for a portfolio will __________ on the degree of correlation between the assets
- Correlation is the way the returns of assets move in relation to each other — can be ________ or ________
Modern Portfolio Theory
- Modern Portfolio Theory (MPT) posits that it is possible to achieve maximum risk reduction by combining assets together in an optimal way
-> The amount of potential risk reduction for a portfolio will depend on the degree of correlation between the assets
- Correlation is the way the returns of assets move in relation to each other — can be negative or positive
Correlation – how does it work
- The correlation coefficient is a measure that ____________ the degree to which two variables’ movements are associated
- The range of values for the correlation coefficient is ______ to _______:
- assets with +1 correlation coefficient (positively correlated assets) eliminate _____ risk
- assets with less than +1 correlation coefficient eliminate __________ risk
- assets with -1 correlation coefficient (negatively correlated assets) eliminate ______risk
- To ________ the overall risk of a portfolio, it is best to _________ assets that a have _______ (or________ ) correlation
Correlation – how does it work
- The correlation coefficient is a measure that determines the degree to which two variables’ movements are associated
- The range of values for the correlation coefficient is -1.0 to 1.0:
- assets with +1 correlation coefficient (positively correlated assets) eliminate no risk
- assets with less than +1 correlation coefficient eliminate some risk
- assets with -1 correlation coefficient (negatively correlated assets) eliminate all risk
- To reduce the overall risk of a portfolio, it is best to combine assets that a have negative (or low positive) correlation
Diversification and minimisation of investment risk - continued
We cannot diversify market risk but we can diversify company specific risk by holding a share portfolio in multiple companies – by the time we have purchased ________ companies we have reduced our non-systematic risk to very low levels
Diversification and minimisation of investment risk - continued
We cannot diversify market risk but we can diversify company specific risk by holding a share portfolio in multiple companies – by the time we have purchased 10 – 30 companies we have reduced our non-systematic risk to very low levels
Components of risk
- Diversifiable risk, also known as unsystematic risk, results from uncontrollable or random events, such as _________, ____________ and ___________
- Systematic risk, also called non-diversifiable risk or market risk, is attributed to forces such as ______, _________ and ___________ that affect all investments and thus are not unique to a particular investment
- Total risk = systematic – non-diversifiable risk plus non-systematic - company specific risk
- total risk is measured by _____________
- systematic risk is measured by ___________
Components of risk
- Diversifiable risk, also known as unsystematic risk, results from uncontrollable or random events, such as labour strikes, _legal action_s and regulatory actions
- Systematic risk, also called non-diversifiable risk or market risk, is attributed to forces such as war, inflation and political events that affect all investments and thus are not unique to a particular investment
- Total risk = systematic – non-diversifiable risk plus non-systematic - company specific risk
- total risk is measured by standard deviation
- systematic risk is measured by Beta
Holding Period Return
Holding Period Return (HPR) is the total return earned from ________an investment for a specified holding period (usually _______ or _______)
Holding Period Return
Holding Period Return (HPR) is the total return earned from holding an investment for a specified holding period (usually 1 year or less)
