Chapter 15 Part 5 Flashcards Preview

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Flashcards in Chapter 15 Part 5 Deck (20)
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Business Risk

the risk that certain circumstances or factors may have a negative impact on the operation or profitability of a given company. For example, a company may suffer due to increased competition, a decrease in demand for its goods or services, or adverse economic conditions.


Regulatory Risk

the risk that is based on regulatory changes that may have a negative impact on an investment's value. For example, an FDA announcement denying approval of a new drug may cause a pharmaceutical company's stock to drop in price.


Legislative Risk

the risk that new laws may have a negative impact on an investment's value. Changes in the law can occur at any level of government and potentially can affect all sorts of investments. For example, changes in local zoning laws would greatly affect the profitability of a real estate developer.


Political Risk

"the risk that is simply defined as the risk that foreign investors will lose money due to changes that occur in a country's government or regulatory environment. This risk is typically associated with emerging markets countries and may include acts of war, terrorism, and military coups. A milder example would be a new political party taking power and deciding to
nationalize a sector of the economy."


Liquidity Risk

the risk that investors may be unable to dispose of a securities position quickly and at a price related to recent transactions. This type of risk tends to increase as the amount of trading in a particular security decreases. For example, the shares of large blue-chip companies are highly liquid, while the stocks of small companies are typically less liquid.


Reinvestment Risk

the risk that an investor will not be able to reinvest her principal at the same interest rate after a bond matures or is called. This situation typically occurs when interest rates are falling. The investor usually has two choices-accept a lower rate of return, or assume a higher degree of risk to keep her returns stable. reinvestment risk is also evident when an investor receives interest from a bond and reinvests at a lower rate, due to a decline in market interest rates.


Currency (Exchange-Rate) Risk

the possibility that the value of foreign investments will be less in the future due lo changes in exchange rates.


If the dollar is strengthening against foreign currencies, then U.S. goods and services will become

more expensive for foreigners. This should result in an increase in foreign goods imported into the U.S. and a decrease in the amount of U.S. goods exported to other countries. As a result, the U.S. balance of trade would worsen and the trade deficit would increase. Balance of trade refers to the difference between the monetary value of imports and exports in an economy over a certain period.


Capital Risk

risk that an investor could lose all or a portion of her investment (e.g., if the issuer defaults).


Credit Risk

also known as default risk, is the risk that the issuer will not make payments as promised.


Call Risk

risk that an issuer may decide to pay the bondholder prior to maturity. The amount paid to the bondholder may be the face value or an amount above the principal. This excess payment above par is known as the call premium.


According to the efficient market hypothesis, buying and selling securities is more a

game of chance than it is skill. If markets are efficient and current, then prices will reflect all known information; therefore, buying stocks at a bargain price is impossible. Since the prices adjust almost instantly to reflect new information, consistently outperforming the market for a significant length of time is impossible. The only way for an investor to obtain higher returns is to take on more risk. The efficient market hypothesis describes three forms of efficiency: weak, semistrong, and strong.


Weak-form efficiency asserts that

all past market prices and data are fully reflected in securities prices. Price changes result from the release of new information, which arrives randomly. However, the fact that randomly released information impacts stock prices dismisses the idea that patterns exist in the stock market. Therefore, using technical analysis would not allow investors to identify securities that are undervalued, since technical analysis attempts to discover patterns in stock price movements and then uses those patterns to predict future movements.


Advocates of weak-form efficiency believe that

fundamental analysis may be used to identify stocks that are undervalued or overvalued. Therefore, researching financial statements makes it possible to identify profitable companies.


Semistrong-Form Efficiency

This form takes the weak-form efficiency one step further by stating that security prices reflect all publicly available information (not just past information). This thery states that neither technical nor fundamental analysis would provide investors with a predictable edge. Therefore, market information, analyzed by technical traders, such as trading volume and other public financial information that fundamental analysts may consider relevant, such as earnings, dividend announcements, financial ratios, and accounting practices, does not allow investors to achieve better returns since this information is already available to every investor. Over the long term, the only way to gain an advantage in this type of market is to have access to nonpublic information.


Strong-Form Efficiency

the price of a stock includes all the current information about that security, both public and private. This form integrates the ideas of weak and semistrong efficiency by suggesting that any information pertinent to the stock that is known by at least one investor is incorporated into the stock price. Strong-form implies that investors may not increase their returns regardless of the amount of research and analysis conducted on a company. No one can beat the market-not even insiders----so proper asset allocation is an investor's best approach to long-term investing.


there are various investment styles and strategies. The two major categories are

passive and active. Passive strategies make very few, if any, changes to a portfolio. Active strategies attempt to outperform the market by changing investments more frequently.


strategic asset allocation

Allocating assets into an optimal portfolio based on a client's risk tolerance and investment objectives is also called strategic asset allocation. In theory, an optimal portfolio is the best mix of assets, given the client's goals and level of risk aversion. However, since different asset classes show differing rates of return over time, the initial asset allocation will eventually be transformed into some other allocation.


The buy and hold approach is to

do nothing. By not restoring the original strategic asset allocation, transaction costs and tax consequences are minimized. In addition, the portfolio retains any assets that might be steadily appreciating. However, one of the problems with the buy-and-hold approach is that, as the asset mix of the portfolio drifts, its risk/reward characteristics are altered. In particular, its volatility is measured by the portfolio's standard deviation-may become quite different from the original allocation, so different that it may no longer be compatible with the client's risk tolerance.


Systematic rebalancing uses a method of

buying and selling assets on a periodic basis. Through rebalancing, the original strategic asset allocation-and its risk/reward characteristics--may be restored. This approach may be based on either time or value. If using time as the focus, portfolio rebalancing may be done periodically on a monthly, quarterly, or annual basis. On the other hand, if adjustments are triggered by value change, the need to rebalance is based on an asset class growing or shrinking beyond a set tolerance level (e.g., ±10%) from the original allocation. More frequent rebalancing will keep the portfolio closer to its strategic allocation. However, the rebalancing may result in higher transaction costs as some assets are sold and others are purchased.

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