Type of Investment Risk Flashcards
What is investment risk?
The uncertainty that an investment’s actual or realized return, will be different from its expected return.
What is diversification?
The structuring of an individual’s investment portfolio to minimize risk and maximize return.
- Use of low correlation (asset diversification)
- Use of time horizon (time diversification)
What is unsystematic risk?
This is diversifiable risk. It is risk that only affects a particular company, country, and/or sector. Using non-correlated assets can mitigate this risk.
Examples:
Business risk: uncertainty of income
Financial risk: how a businesses financial structure affects value
Default risk: a business can’t pay its debts
Political risk: the political environment affects investment values
Tax risk: the country tax laws can affect business values
Investment manager risk: poor investment managing
Liquidity risk: the ability to sell an asset
Marketability risk: the ability to find a buyer for an asset
What is portfolio diversification?
The commitment to an array of separate investments that are not correlated with each other in order to offset risks that when one investment goes down, the others could go up.
What are the four asset classes for diversification?
Cash and cash equivalents
Fixed income (bonds)
Equities (stocks
Real assets (land, collectibles, precious metals)
What is expected return?
An investor’s estimate of a return, given the economic and market prospects for an investment.
What is total risk?
Systematic + unsystematic risks
For systematic risks, remember PRIME. What is it?
Purchasing power risk Reinvestment rate risk Interest rate risk Market risk Exchange rate risk
What is Beta?
A measure of SYSTEMATIC risk.
The market has a Beta of +1.0. Therefore, any assets that have less than 1.0, are less risky. Assets with more than 1.0, are more risky.
In the measurement calculations, what do the following symbols mean? β = σi = σm = ρim = COVim = W = σp =
β = beta σi = standard deviation of the investment σm = standard deviation of the market ρim = correlation coefficient between the investment and the market COVim = covariance between the investment and the market W = weighting or percentage of a portfolio σp = standard deviation of a portfolio
What is covariance?
COVij = ρijσiσj
Covariance measures the extent to which two variables (two investment returns in this case), either move positively, (together) or negatively (opposite).
COVij = covariance between assets i and j ρij = correlation coefficient between assets i and j σi = standard deviation of asset i σj = standard deviation of asset j
What is standard deviation?
It is an absolute measurement of the variability of the actual investment returns around the average or mean of those returns.
In other words, it tells the investor how far from the mean, they could expect the investment’s actual return, to likely vary. The higher the number, the wider the variable.
What is normal probability distribution?
It is the location of the arithmetic mean of a series of observations.
What is the mean, median, and mode?
The mean is an absolute: the sum of all observations, divided by the number of observations.
The median is the central value in a series of values (4, 7, 8, 11, 13 = median 8)
The mode is the observation value with the greatest frequency.
What is normal probability distribution?
Given the mean,
One observation will occur 68% of the time within one standard deviation
One observation will occur 95% of the time within two standard deviations
One observation will occur 99% of the time within three standard deviations.
Anything outside that, is an outlier.
Ex: 10% return with 5% standard deviation
1 standard deviation = 5% and 15%
2 standard deviations = 0% and 20%
3 standard deviations = -5% and 25%
What is the Z-statistic and how is it interpreted?
The Z-statistic is the measurement of standard deviations above or below the mean. If it is a positive number, then it is that many standard deviations above the mean. If is a negative number, then it is that many standard deviations below the mean.
What is a lognormal probability distribution?
A curve in which the series of observations is skewed to the left, (i.e. the mean is to the right of the peak). This implies that there is a greater than 50% chance that an observation selected at random will fall to the left of the mean.
What is skewness?
This measures how far the actual outcomes of a probability distribution deviate from the arithmetic mean. Come in two shapes:
Right tailed is positively skewed. Mode, Median, Mean ((positive is right) mean on the right)
Left tailed is negatively skewed. Mean, Median, Mode (mean on the left)
What is kurtosis? What are the secondary names (low and high) for kurtosis?
Kurtosis measures the degree in peak from the mean.
If the peak is narrow and tall, (high) kurtosis measurement is that deviation from the mean is less likely. AKA leptokurtic
If the peak is a hill and spread out, then the (low) kurtosis measurement is the deviation from the mean is more likely. AKA Platykurtic (plateau)
What is semivariance?
A measurement of the average square deviation below the mean. This measures real risk - downside risk only. The lower the semivariance, the less risky the investment.
What is coefficient of variation (CV)?
CV = standard deviation / mean return
It is a measurement of total risk PER UNIT of expected return. Instead of looking at just the standard deviation for an entire investment, CV measures standard deviation / the mean return to get a risk measurement per unit for a more calculated decision choice.
The higher the CV, the more risky the investment.
What are the abbreviations for covariance and coefficient of variation?
CV = coefficient of variation COV = covariance
What is the correlation coefficient?
R(or ρ) = COV ij / σ i × σ j
Unlike the covariance formula, the correlation coefficient bounds the number between -1 and +1, the latter being perfectly aligned to the investment (or market) it’s being measured against, and the former being perfectly opposite.
The closer to -1 you are means the more diversification you have.
What is the coefficient of determination?
It is R-squared or the square of the correlation coefficient
It describes the percentage of variability in one variable that is explained by changes in a second variable.
Beta becomes less reliable as R-squared lowers from 100.
For testing, look for R-squared of 70% or better.
What formula determines systematic risk?
R-squared of correlation coefficient
Which one of these factors has the greatest impact on the standard deviation of a two-asset portfolio?
The weight of each security in the portfolio
Covariance
The standard deviation of each security in the portfolio
The portfolio’s beta
Covariance
R2 or Coefficient of determination, determines which kind of risk?
Systematic
In a positively skewed distribution, what is the order (from lowest value to highest) for the distribution’s mode, mean, and median values?
Mode, median, mean
Median, mode, mean
Mean, median, mode
Mode, mean, median
Mean, median, mode
