7. Risk Flashcards
(32 cards)
“Risk can be defined as the possible variation in an outcome from what is expectedto happen.”
This definition of risk contains three important elements:
— Risk is about variability because future events cannot be predicted with certainty.
— Risk relates to our expectations of what will happen.
— Risk arises because what actually happens could differ from what is intended or expected to happen.
Stock‑market‑linked investments are termed…
‘asset‑backed’ investments
* Because their value is backed by the value of the assets underlying the shares or investment.
Over the longer term, asset‑backed investments are more likely to provide protection against inflation.
What does the term equity risk premium (ERP) refer to?
7.2 The equity risk premium
The equity risk premium (ERP) refers to the difference in returns between equities and low-risk investments like government bonds, compensating for the higher risk of investing in equities.
A measure of risk vs reward
At a high level, risk can fall into one of several categories… Investment risk
the probability/likelihood of achieving/failing to achieve the
expected return on any particular investment;
At a high level, risk can fall into one of several categories… operational risk
risk of losses stemming from inadequate or failed internal
processes, people and systems, or from external events;
At a high level, risk can fall into one of several categories… business risk/reputational risk
the exposure that a company has to factors that will lower its profits/earnings.
Name 9 types of risk that relate to investments
- Captial risk
- income risk
- shortfall risk
- liquidity and access risk
- interest risk
- inflation risk
- currency risk
- systematic and non-systematic risk
- Gearing.
What is captial risk?
The risk of losing some, or all, of the original capital invested.
Deposit-based accounts reduce this risk, but are prone to inflation risk
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What is Income risk
Two forms?
- Income generated will not keep pace with inflation
* Particularly with the case with fixed-income vehicles like annuities and fixed-interest gilts - Income from an investment will reduce in notional terms
* Particularly with investmens that have a variable rate of interest
* Or when a company reduces dividends paid on shares
What is shortfall risk?
Give an example
A risk based out of expectations
If the investment has been taken out for a specific purpose and it does not achieve it’s goal.
Example: Endowments taken out to support an interest-only mortgage - the endowment may not perform well enough to cover the mortgage amount at maturity
What is liquidity risk?
- Ease and time taken to access to funds
- Price of the asset can be a factor - property for example, limits the total amount of potential buyers
What is interest risk?
two ways its shows
- Savers in variable-rate accounts run the risk that their interest rate will reduce - and no longer provide the income they desire
- Fixed interest savings accounts with penalites may receive a lower rate relative to market if rates increase - unable to withdraw without penalty
what is inflation risk?
Inflation errodes the true buying power of an asset or fund over time.
Investors should look for investments that are likely to provide a real return over time.
Borrows actually tend to benefit from higher inflationary rates, as the the ‘real’ value of their debt reduces over time.
What is currency risk?
Check example on page 250
Where an investment is made overseas or in a fund that invests overseas, there is currency risk: the risk that currency fluctuation might erode the value of the investment.
When sterling rises in value against the foreign currency, it has the effect of reducing the value of the investment in sterling terms. Conversely, when sterling falls against the foreign currency, the value of the investment rises in sterling terms.
What is Systemic risk?
Systemic risk in banking is a risk that affects the entire financial market or system, not just specific participants.
The main sources of concern for systemic risks are banking and insurance.
* Banks are highly geared – they have large amounts of liabilities relative to the amount of their own capital.
* There is a high need for liquidity.
* There is high interdependence between banks
* Potential for a ‘run’ on the banks, leading to large withdrawals of money by customers.
What is Systematic risk?
Known as market risk
Systemic risk begins with the impact on a specific business or group of businesses and spreads through the wider market because of the interlinkages between businesses.
Systematic risk springs from an event external to the market that affects the entire market.
What is non-systemic risk?
How can non-systemic risk be mitigated by an investor?
Non‑systematic risk relates to specific sectors and investments. It is the risk of a
particular share failing to deliver expected returns, or collapsing due to factors more to do with the company or companies in a specific sector than the markets or economy in general.
Non‑systematic risk can be diluted by diversifying the portfolio over a number of
companies’ shares, or over a number of market sectors.
What is gearing risk?
Which financial instrument is gearing particularly relevent to?
Gearing is where a company borrows to invest.
* Gearing is usually expressed by showing the borrowing as a percentage of capital and resvers.
* Sometimes referred to as leverage
The higher the proportion of debt to the capital and reserves of the company, the more volatile the investment.
Particularly relevant to investment trusts
Gearing explained?
The investment trust manager borrows the funds to buy assets that they feel are likely to increase in value
As a result of the initial purchase, the fund will see an initial rise in asset value, created by the additional assets.
if the assets grow at a higher rate than the interest paid on the borrowing, the investor wins through increased dividends, share price or net asset value (NAV).
Defined Net asset value (NAV)
The value of the investment trust’s assets, less liabilites, divided by the number of shares.
Gearing increases the volatility of the investment, because the effect of a fall in the value of assets bought with borrowing will be made worse by the effect of the interest payments on the overall picture
Volatility
How is it measured? give example how this can be shown on share return
A measure of how much the value of a share or fund fluctates over a set period, when compared with its previous performance, and to an average of its sector or specified benchmark
Measured by its standard deviation from the average or benchmark return (Known as the ‘expected return’
- If a shares value stays close to the expected return, it is said to have low volatility
- For example, returns from an investment with a standard deviation of 1 and an expected return of 5% would be expected to fluctuate between 4% and 6% presenting low volatility
General rule regarding volatility and a normal distribution curve
- 68 per cent of the data is contained within 1 standard deviation of the mean (benchmark),
- around 95 per cent within 2 standard deviations
- and almost 100 per cent within 3 standard deviations.
To give an example, if a share has an expected return of 10 per cent and a standard deviation of 15 we can predict that:
* roughly 68 per cent of the time the return will be within one standard deviation – minus 5 to plus 25 per cent;
* roughly 95 per cent of the time the return will be between two standard deviations – minus 20 per cent to plus 40 per cent
* 99 per cent of the time the return will be between three standard deviations – minus 35 per cent to plus 55 per cent.
What are Beta factors?
7.4.2 Measures of volatility
Beta factors measure the volatility of a share or collective fund against the whole market or against a benchmark such as a specific FTSE index.
The beta measures are:
* beta factor 1 – where the holding moves in line with the index or benchmark, which is assumed to have a beta of 1
- beta factor over 1 – where the holding fluctuates more widely than the benchmark, making it more volatile and more risky than the benchmark;
- beta factor below 1 – where the holding fluctuates less than the benchmark.
A cash‑based investment has no direct links with the stock market and so would have a beta close to 0.
The higher the beta, the more volatile and risky the investment. Even where the investor has diversified the portfolio, if the average beta of the investments in the portfolio is above 1, the portfolio is riskier than the market in general.
