3. Investment Risk

Question 0

What are the 15 sources of investment risk?

Answer 0

Sources of investment risk?

1. Systematic (Market) Non-diversifiable Risk
2. Business Risk (a.k.a. Non-Systematic Risk)
3. Inflation (Purchasing Power) Risk
4. Interest Rate Risk
5. Price Risk
6. Reinvestment Rate Risk
7. Credit Risk
8. Liquidity Risk
9. Marketability Risk
10. Political Risk
11. Sovereign Risk
12. Exchange Rate (Currency) Risk
13. Tax Risk
14. Investment Manager Risk
15. Additional commitment risk

Question 1

What is Investment Risk?

Answer 1

Investment Risk?

1. Pure risk – only the chance of loss or no loss
   Example: auto insurance
2. Speculative risk – acceptance of the risk of a loss in exchange for the hoped for expected return
   –also defined as the variability in an investment’s rate of return

Question 2

What is Systematic (Market) Non-diversifiable Risk?

Answer 2

Systematic (Market) Non-diversifiable Risk – risk from events that affect all investments (the entire financial system)

1.Inflation risk and interest rate risk are components of market risk.

2.Market risk can also derive from political, economic, demographic, or social events and trends.

Example of specific market risk event: September 11, 2001 terrorist attack

Question 3

What is Business Risk (a.k.a. Non-Systematic Risk)?

Answer 3

Business Risk (a.k.a. Non-Systematic Risk)?

Risk that comes from events that affect a single firm or small number of closely related firms

Example 1: a corporate treasurer may be accused of embezzling substantial sums of money.

Example 2: a decline in the price of imported steel.

Question 4

What are the 2 factors that affect the degree of business risk?

Answer 4

Operating risk and financial risk are two factors which affect the degree of business risk for a company.

Question 5

What is the only way to reduce business risk?

Answer 5

Diversification is the only way to reduce business risk.

Question 6

What is Inflation (Purchasing Power) Risk?

Answer 6

Inflation (Purchasing Power) Risk?

1. the variation in real returns caused by changes in the general level of prices.
2. Inflation – when the general level of prices rise
3. Disinflation – when the general level of prices fall

Question 7

Which investments are most susceptible to inflation risk?

Answer 7

Investments most susceptible to inflation risk are fixed-income investments such as:

1. savings accounts,
2. CD’s,
3. bonds,
4. bond funds,
5. life insurance cash values,
6. and fixed annuities.

Question 8

What is a Nominal Return and its equation?

Answer 8

Nominal rates are the rates we see and work with very day.

Equation: Nominal rate = (1 + real rate) * (1 + inflation rate) – 1

Note: subtracting 1 reflects a return of principal.

Question 9

Example of nominal return:

Jeff Robins tells his financial planner that he wants to earn a 10 percent rate of return because he wants a 4 percent real rate of return and he expects a 6 percent inflation rate. The financial planner should advise Jeff that he is mistaken about what he needs to earn.

Answer 9

Nominal rate = (1 + real rate) * (1 + inflation rate) – 1

Real rate = 0.04
Inflation rate = 0.06

(1 + .04) * (1 + .06) 1 = .1024, or 10.24%

Jeff actually needs a 10.24 percent nominal rate of return based on his goal and his inflation expectation.

Question 10

What is the Real (Inflation-Adjusted) rate?

Answer 10

Real rate =[(1 + nominal rate) / (1 + inflation rate)] - 1

Question 11

What is Interest Rate Risk?

Answer 11

Interest Rate Risk?

Interest rate risk refers to the degree to which an investment is affected by changes in interest rates.

Question 12

What are the 2 components of interest rate risk?

Answer 12

2 components of interest rate risk:

1. Price Risk – refers to the fact that any change in market interest rates typically leads to an opposite change in the value of investments—when interest rates rise (fall), the value of an investment declines (increases).

Example: instruments that have a contractually specified rate or return such as bonds.

2. Reinvestment Rate Risk – the risk related to what the interest rate will be when income and/or principal from
   investments is revinvested.

Example: If rates fall, a bondholder may not get as high of a return as previously and thus he will earn less if he reinvests.

Question 13

What is Credit Risk?

Answer 13

Credit Risk?

1. a.k.a. default risk
2. the risk that contractual payments on debt securities will not be honored.

Question 14

What is Liquidity risk?

Answer 14

Liquidity risk refers either to the inability to sell an asset quickly, or the need for a price concession to sell quickly.

Question 15

What is marketability risk?

Answer 15

Marketability Risk refers to the difficulty of selling an asset for its fair market value.

Question 17

What is political risk?

Answer 17

Political Risk includes the effects of trade disputes, wars, political unrest, tariffs, corruption, and expropriation.

Question 18

What is sovereign risk?

Answer 18

Sovereign Risk is the risk of a government defaulting on its debt obligations.

Note: When a bonds are said to be issued by PIIGS, it stands for Portugal, Ireland, Italy, Greece, and Spain.

Question 19

What is Exchange Rate (Currency) Risk?

Answer 19

Exchange Rate (Currency) Risk?

Movements in currency exchange rates.
Relevant for individuals who are directly investing in foreign markets.

Question 20

What are the 3 steps to solve for return after adjusting for exchange rates?

Answer 20

Three steps to solve for return after adjusting for exchange rates:

1) Ascertain amount invested in foreign currency

2) Calculate value at anticipated rate after specified period of time

3) Divide value by current exchange rate

Question 21

What is tax risk?

Answer 21

Tax Risk?

1. Tax risk is the extent to which an investment is exposed to changes in tax laws
2. Tax diversification and basing goals on economic value help reduce tax risk.

Question 22

What is Investment Manager Risk?

Answer 22

Investment Manager Risk?

the potential failure of the asset manager to select good investments, effectively anticipate and act on market movements, and/or otherwise execute an investment strategy consistent with the interests of the investors in his or her portfolio.

Question 23

What is Additional Commitment Risk?

Answer 23

Additional Commitment Risk?

When an investment requires the buyer to put additional money into the investment in the future.

Question 25

What is the difference between Liquidity Risk and Marketability Risk?

Answer 25

What is the difference? All liquid assets are marketable, but not all marketable assets are liquid.
Example: Stocks that trade on the major exchanges are marketable but not liquid.