Chapter 7: Risk and Return

Question 1

Risk

Answer 1

The probability that an investor will be negatively influenced by the deviations of the actual performance from expected return on investment.

Question 2

2 Broad Categories of Risk

Answer 2

• Systematic risk

- Non-systematic risk

Question 3

Systematic Risk

Answer 3

All risks that are the result of changes in the total economy and which subsequently influence all enterprises and investments (although not to the same extent).

Question 4

5 Systematic risks

Answer 4

• Interest rate risk
• Cyclical risk
• Inflation risk
• Exchange Rate risk
• Market risk

Question 5

Interest rate risk

Answer 5

The probability that changes in interest rates may have a negative effect on the return of an investment.

Question 6

If interest rates should increase, what should happen to the price of shares

Answer 6

drop

Question 7

Explain the inverse interest-rate-to-price relationship in the case of Fixed income securities

Answer 7

• Since the FIS have a fixed coupon rate, increases in interest rates will mean that investors can obtain higher returns on similar investments in the market
• The price of the FIS will come under pressure, since investors will sell the securities and buy new FIS with higher coupon rates
  If interest rates decrease, the opposite can be observed: an increase in the demand for the FIS will cause the price to increase.

Question 8

2 Explanations for inverse relationship between the interest rate and share price

Answer 8

• A difference exists between the risk exposure of a share investment and a fixed deposit. Investors may therefore decide to invest their funds in the safer investment option (fixed deposit) if the return (interest rate) is high enough.
• An increase in interest rates results in higher finance costs for investors that use debt capital to finance their investments. If the return on the share investment is not high enough to compensate for the increase in interest rates, investors will sell their shares, resulting in decreasing prices.

Question 9

Cyclical risk

Answer 9

The probability that returns will be negatively influenced by changes in the economic cycle.

Question 10

3 Methods for reducing cyclical risk

Answer 10

• Diversification over time
• Diversification between different types of investments
• Timing

Question 11

4 Approaches to hedge against inflation

Answer 11

• International diversification
• Balanced diversified portfolio
• Timing
• Inflation linked securities

Question 12

Exchange rate risk

Answer 12

The uncertainty regarding returns for investors that are exposed to foreign securities.

Question 13

3 Approaches to protect against exchange rate risk

Answer 13

• Exchange rate cover
• Thorough analysis of company
• International diversification

Question 14

Exchange rate cover

Answer 14

If investors are expecting investment revenue in another currency it is possible to obtain exchange rate cover (at a cost) from a financial institution.

Question 15

Market risk

Answer 15

The probability that the market price of an investment will differ from its intrinsic value due to irrational investor behavior.

Question 16

4 Strategies to hedge against market risk

Answer 16

• Timing
• Longer investment term
• International diversification
• Thorough analysis of the share

Question 17

3 Types of Non-systematic risk

Answer 17

• Operating risk
• Financial risk
• Industry risk

Question 18

Non-systematic risk

Answer 18

Risks that result from the nature of the activities of the enterprise (result of the actions).

Question 19

Operating gearing factor (formula)

Answer 19

X(p-v)/(X(p-v) - VK)

Where 
X = number of units produced and sold
p = sales price
v = variable price
VK = total fixed cost

Question 20

Measure of financial risk

Answer 20

Can be measured by means of the financial gearing of an enterprise.

Question 21

Financial gearing factor (formula)

Answer 21

Return on total assets / Return on shareholders’ equity

Question 22

2 Factors to be considered with exposure to financial risk

Answer 22

• Analysis of an enterprise’s capital structure

- Market interest rates

Question 23

Beta of a share

Answer 23

Provides an indication of the share’s price sensitivity relatively to the prices of other shares in a specific market.

Question 24

Beta values indicate: ( 1)

Answer 24

ß > 1: Share is more sensitive than the market
ß < 1: Share is less sensitive than the market
ß = 1: Share prices move together with the market