Types of Investment Risks and Quantitative Investment Concepts Flashcards
Risk
realized returns will not equal expected returns
Systematic risk
- non diversifiable (cannot be avoided)
- PRIME
- expressed by beta
Purchasing power risk
loss of purchasing power through inflation
eg. rising price of good erodes purchasing power on fixed income securities
Reinvestment rate risk
risk that proceeds available for reinvestment must then be invested at a lower interest rate
eg. when CDs mature, investors may have to invest proceeds on new lower yielding CDs
Interest rate risk
change in interest rates will cause the market value of the fixed income security to fall
eg. interest rates rise, bond prices fall
Market risk
the risk of the overall market, cannot be avoided if you are invested
eg. downside swing of market affects stock prices
Exchange rate risk
risk associated with changes in the value of currencies
eg. value of foreign securities falls and rises with value of currency of issuer
- uncertainty in returns after they convert foreign currency back to own currency, if the rates moved
Country risk
political risk
uncertainty of returns caused by the possibility of major political changes and economic environment
closely related to exchange rate risk
Unsystematic risk
diversifiable (nonsystematic)
can be largely eliminated by owning securities with low correlation
- Business and Financial risk
Business Risk
risk related to the nature of a firms corporation
eg. demand for corps products declines due to new tech
Financial risk
risk related to how the firm finances its assets
eg. corp is forced to close because it cant service its debts
Total Risk
-expressed by standard deviation
- combination of systematic and unsystematic risk
Political risk
sovereignty risk
- risk that the foreign government will default on its loan or fail to honor business commitments because of a change in national policy
Devaluation
lowering of the value of a currency relative to the currencies of one or all other nations
- can result from a rise in value of other currencies
- in real example if yen is worth 90 to 1 dollar and goes up to 100 to 1 dollar. it is actually losing value relative to dollar. for 1 dollar i can buy more yen bc its cheaper now
Revaluation
increase in the currency value
- ways it increases is actually getting closer to the actual 1:1 conversion. So the currency can decrease, and still be revaluation.
- Eg. Yen was 100 to 1 dollar. Yen decreased to 80 to 1 dollar. less to buy one dollar, value went up
- my $1 buys less now, dollar lost some value
Investing internationally
- risk reduction through lower correlation to US stocks
- exchange rate risk
- less efficient than us markets because of fewer analysts
- typically taxed twice, once in foreign country and again in US
Liquidity
security that can be sold or purchased without delay and substantial change in price absent new information
- describes both transaction speed and stability of price
Marketability
- only to the speed of the transaction
- price can significantly different from last transaction
- savings/checkings/MMA are not marketable, they are redeemable. Needs to be traded. Not MF either
- ## REIT, ETF< closed end, brokered CD
Liquid vs Nonliquid
Liquid
- short term CD
- laddered CD
- insurance cash value
- open end money market mutual funds
Nonliquid
- open end mutual funds
- closed end funds
- etf
- brokered CD
Mean
middle point between two extremes
- arithmetic mean: sum of each value divided by total number of values
Normal vs lognormal distribution
Normal
- possible range of returns for a portfolio
(pos or neg)
- mean is likely return
- return is symmetrical about the mean
- more likely to be close to mean than far away
- bell curve
Lognormal
- possible ending portfolio value in $ at a future date (never less than 0) - clients monte carlo report/cash flow report, less at end
- upper limit is unlimited
- positively skewed (most values near lower limit)
- mean will be to the right of the highest point of the curve
Correlation Coefficient
- expresses the extent to which the movements of securities in the same portfolio are similar or not (covariance too)
- corr. coef. falls within specific range
- values range from +1 (perfectly pos. correlated) and -1 (perfectly neg correlated)
-covariance and and standard deviation are needed to calculate
Covariance
measures the extent to which two stocks are related to each other or how the price movements of one of the securities is related to the price movements of a second security
- covariance considers infinite possibility of outcomes
Perfectly positively correlated investments
- +1
- securities move exactly together
- no reduction in portfolio risk
- maximum risk
- SD of portfolio is equal to weighted average of SD of two assets
Perfectly negatively correlated investments
- 1
- move exactly opposite one another
- risk is completely eliminated
- SD is 0
Coefficient of variation (CV)
- measure of relative variability used to compare investments with widely varying rates of return and standard deviation
- SD / mean
- indicated risk per unit of expected return
- higher the results, higher the risk
Standard deviation vs beta
- both used to express risk of a security
- SD measures variability of returns used in a nondiversified portfolio and is the measure of total risk. has both systematic and unsystematic risk
- beta measures volatility of returns in a diversified portfolio and is a measure of systematic risk. We diversified all the nonsystematic risk out so whats left is the systematic risk and so its diversified in a way
Calculating SD of single investment
Enter return then sigma key
gold 7 key for mean
gold 8 key for SD
Applying SD
absolute measure of variability of results around mean
68% falls within 1 SD
95% falls within 2 SD
99% falls within 3 SD
Portfolio weighted SD
The risk (SD) and return can be determined by multiplying risk (weighting) and return for each stock and adding them together
Beta
- measure of volatility of a particular securities rate of return or price relative to the volatility of the market as a whole
- calculated based on the historical movement of the securities price
- market as a whole has constant beta of 1.0. a security’s beta may be more or less or equal
- beta over 1, more volatile than stock market. the greater the more systematic risk, no unsystematic risk
- beta under 1 less volatile than stock market
