Chapter 6: Investment risk

Question 1

Define inflation

Answer 1

An overall upward price movement of goods and services in a economy

Question 2

What is the ‘nominal’ return

Answer 2

The return an investment gives without adjusting for inflation

Question 3

What is the ‘real’ return

Answer 3

The return from an investment after considering inflation

Question 4

Formula for real rate of return

Answer 4

1 + RROT = (1 + Nominal Rate)/(1 + Inflation Rate)

Question 5

What is total return

Answer 5

The returns on an investment both from its income production, and any other capital gains (or losses) that it generates

Question 6

What is holding period returns

Answer 6

The total return on an asset or portfolio over the period during which it was held.

Question 7

How do you calculate holding period returns

Answer 7

The sum of income over a particular period, divided by the initial period value

Question 8

formula for compound interest

Answer 8

s= x(1 + r)^n

Question 9

what is present value

Answer 9

the amount of money which must e invested now for n years at r% interest to earn a given future sum of money

Question 10

What is currency risk

Answer 10

The risk arrising from fluctuations in the value of currencies against one another

Question 11

what is interest rate risk

Answer 11

The risk that interest rates move against the investor

Question 12

What is issuer risk

Answer 12

The risk that the bond issuer, whether government or corporate, gets into financial trouble and cannot keep up with interest payments, or defaults on the final payment

Question 13

What types of risk contribute to equity risk

Answer 13

Liquidity risk, growth risk, volatility risk, strategic risk

Question 14

What is growth risk

Answer 14

the risk that, if investing for growth, the company may not grow as expected

Question 15

What is volatility risk

Answer 15

The risk that the performance of an investment can change quickly, in either direction over a short period of time.

Question 16

What is commodity risk

Answer 16

The risk of an adverse price movement in the value of the commodity

Question 17

What is property risk

Answer 17

Location of the property
the effect of the use of the property on its value
the credit quality of the tenants
the length of the lease

Question 18

What is Liquidity risk

Answer 18

Liquidity risk refers to the likelihood of being unable to transform assets into cash

Question 19

Examples of an investments fund benchmark

Answer 19

Performance of peer group funds
relevant market index

Question 20

What is the beta factor

Answer 20

Measures the volatility on an investment relative to the market or benchmark

Beta factor of 1 moves in line with the market
Beta factor > 1 varies more widely than the market
Beta factor < 1 varies less than the market

Question 21

Over what time period are beta factors calculated

Answer 21

36 months

Question 22

What is alpha factor

Answer 22

Used when assessing the performance of a fund or portfolio, and refers to the extent of any outperformance against the benchmark

Question 23

What is a disadvantage of alpha

Answer 23

Does not distinguish between underperformance caused by incompetence and underperformance caused by fees

Question 24

What is the Sharpe ratio

Answer 24

Uses a concept called ‘risk free return’. This risk free return rate is the rate that it is assumed can be obtained by investing in financial instruments with no default risk.
The Sharpe ratio measures the excess return of a portfolio over the risk-free interest rate, for each unit of risk assumed by the portfolio

Question 25

Sharpe ratio formula

Answer 25

((Return on the portfolio) - (Risk free return))/Standard deviation of portfolio

Question 26

What does a high Sharpe ratio mean

Answer 26

The higher the Sharpe ratio, the better risk adjusted performance of the portfolio, and the greater implied level of active management skill

Question 27

What is the information ratio

Answer 27

Compares the excess return achieved by a fund over its benchmark, to the funds tracking error (Tracking error is its standard deviated compared to benchmark)

Question 28

Information ratio formula

Answer 28

Mean of excess returns/Standard deviated of excess return from benchmark

Question 29

What is private equity

Answer 29

An illiquid asset class consisting of equity securities in operating companies that are not publicly traded on a stock exchange

Question 30

Advantages of private equity

Answer 30

Potential for higher returns and lack of correlation to 'standard' investment

Question 31

What is venture capital

Answer 31

A type of private equity, typically provided to early-stage, high-potential, growth companies in the hope of generating a return through an eventual sale of the company once it has become successful

Question 32

Advantages of venture capital

Answer 32

Tax advantages - typically tax relief is given on the investment Potential for higher returns then can be achieved by mature companies Lack of correlation with more standard investment

Question 33

What is responsible investment

Answer 33

RI began as a niche investment area, serving the needs of those who wished to invest ethically. In recent years it has become much more popular

Question 34

What is asset allocation

Answer 34

The macro equivalent of diversifying a portfolio to reduce risk

Question 35

What is tracking error

Answer 35

A measure of how closely a portfolio follows the index to which it is benchmarked, and it can be calculated either as a historical or a predicative indicator. Tracking error is 'realised' or 'ex post' while predictive tracking error is 'ex ante'

Question 36

What is an investment mandate

Answer 36

It is set out by the investment manager's company and determines the fund's aims, the limits within which it is supposed to invest, and the investment policy it should follow

Question 37

What is optimisation

Answer 37

Often referred to as mean-variance optimisation, it is the construction of techniques to obtain the best expected returns from the riht mix of correlations and variances

Question 38

What is hedging

Answer 38

Hedging is a means of reducing the risk of adverse price movements by taking an offsetting position in a related product. It is a means of insuring against market risk

Question 39

What are the four main areas where a portfolio will benefit from monitoring, management and reporting

Answer 39

Peer review with other internal fund managers Risk review with internal independent fund manager s Monitoring for mandate compliance Performance attribution reporting