Investment Risks

Question 1

Systematic Risk

Answer 1

Systematic risk refers to the risk inherent to the entire market or market segment. Systematic risk, also known as undiversifiable risk, volatility risk, or market risk, affects the overall market, not just a particular stock or industry.

Question 2

Unsystematic Risk

Answer 2

Unsystematic risk refers to risks that are not shared with a wider market or industry. Unsystematic risks are often specific to an individual company, due to their management, financial obligations, or location. Unlike systematic risks, unsystematic risks can be reduced by diversifying one’s investments.

Question 3

Marketability vs. Liquidity of assets

Answer 3

Marketability refers to the ability to sell something. Liquidity not only means the ability to convert the asset to cash quickly, but also without a significant loss of the principal.

Question 4

Skewness

Answer 4

A negative skew occurs when there are many (mode and median) returns above the average, however the average is lower than these observations due to a small number of extreme results in the left tail (below the mean). Stock market returns, for instance, exhibit a negatively skewed distribution. This should be evident by the fact that there are many more positive return years than negative ones. Although, when the market is negative, it tends to be down by a larger margin.

In contrast, a positively skewed distribution has many (mode and median) observations below the mean. However, in this instance a smaller number of outsized positive results push the mean higher. A good investment example of this is venture capital investing. It is expected that many venture companies will not provide significant return, but a small number will have significantly outsized return making the overall portfolio profitable.

Question 5

Expected Rate of Return

Answer 5

The weighted average of all the different rates of return in one probability distribution is called the expected return. It is denoted as E(r).

Question 6

Risk Estimates

Answer 6

Risk is equated with variability, or uncertainty of returns, or the likelihood of the asset to deviate from the expected return over a given time period. A U.S. Treasury bill is as close to risk-free as you can get, which is why its interest rate is often used as the risk-free rate for calculations.

Question 7

Kurtosis

Answer 7

Not only are real-world distributions either positively or negatively skewed, but they exhibit a property known as kurtosis. Kurtosis is a statistical measure that tells us when a distribution is more or less peaked than a normal distribution. A distribution that is more peaked than normal is called leptokurtic (lepto is from the Greek word for slender). A distribution that is less peaked than normal is called platykurtic (platy is from the Greek word for broad). A normal distribution is called mesokurtic (meso is from the Greek word for middle).

By definition, normal distributions have kurtosis equal to three. However, most statistical packages report excess kurtosis, which is kurtosis minus three. Therefore, a normal distribution has excess kurtosis equal to zero, a leptokurtic distribution has excess kurtosis greater than 0, and a platykurtic distribution has excess kurtosis less than 0.

Question 8

Variability of Returns

Answer 8

The wideness of a probability distribution of returns measures variability of return and, therefore, the risk associated with the investment. The variance and the standard deviation of a probability distribution both measure variability of return. They are equivalent measures of total risk.

Question 9

Time Diversification

Answer 9

It is important to realize that implicit in a standard deviation statistic, is a holding period of one year. The concept of time diversification can be easily understood by long holding periods as it relates to the following formula:

Where SD is annual standard deviation, and N is the holding period.

Question 10

Covariance

Answer 10

Covariance measures the tendency for two random variables to move together (to co-vary). Instead of referring to the probability distribution for a single random variable, covariance considers the joint probability distribution of two random variables.

Perfect positive covariance
perfect negative covariance
Zero covariance

Question 11

The Capital Asset Pricing Model (CAPM) Line

Answer 11

A simple linear regression called the Capital Asset Pricing Model is used to measure an investment’s beta and residual variance. It is a time-series regression line used to explain the return of a given asset within a given period (ri,t). It uses the market’s rate of return for a specific period (rm,t) and three other measures, namely, beta (B - slope of the line), alpha (a - y axis intercept), and epsilon (e - a random variable that measures fluctuations above and below the characteristic line). Using this characteristic line, analysts can isolate an investment’s diversifiable and non diversifiable risks.

Question 12

Correlation Coefficient

Answer 12

The correlation coefficient is represented by the lowercase Greek letter rho ( p ). The correlation is a standardized index number that varies in the interval from +1 to -1 and measures how two variables co-vary, or move relative to one another.

Question 13

Beta Coefficient

Answer 13

The beta coefficient, or beta (B), measures the slope of one asset’s Security Market Line. The beta coefficient, for example, of asset i is represented by the symbol Bi
.
Recall, CAPM=Rf+(Rm−Rf)B
—where Beta serves as the slope.

Since the beta of the market (Bm) equals 1, if B i= 1, then the asset has the same volatility as the market.
If Bi > 1, then the rates of return from the asset are more volatile than the returns from the market and the asset is classified as an aggressive asset. The return will be higher than the market if the market return increases. However, if the market return decreases, then the asset’s return will decrease more.
If Bi < 1, then the asset is a defensive asset. Its rates of return are less volatile than the market’s. The asset will earn a positive return when the market return increases, but not as much. Similarly, when the market does decline, it will decline less than the market.

Question 14

Coefficient of Determination

Answer 14

The correlation coefficient squared is called the coefficient of determination, “R2,” or “R-squared.” R-squared measures the portion of the asset’s performance that can be attributed to the returns of the overall market. Since the correlation of coefficient’s value is between -1 and 1, R-squared values can only be between 0 and 1 (the square of anything less than zero will equal a positive number).

If R-squared = 1, then the asset’s return is perfectly correlated with the return of the market.
If R-squared = 0, then the asset’s return has nothing to do with the market’s return.

Question 15

Diversification in Portfolio

Answer 15

R2 around or above .70 is typically a good indicator of diversification and this number will help resolve discrepancies between using standard deviation or beta- based appraisal ratios.

Question 16

Example of Beta and R-squared

Answer 16

A mutual fund is advertised with a beta of 1.6 and a R-squared of 0.24. A sales person tries to sell the fund to you based on the fact that it will outperform the market during an expansion. What is the flaw in his or her sales pitch?

With an R-squared of .24, the fund’s beta is not a reliable statistic to use. Therefore, for the salesperson to imply that a beta of 1.6 will outperform the market during an expansion is inappropriate, since 76% of the fund’s variability of return is due to unsystematic (company specific) forces

Question 17

Alpha

Answer 17

Market Risk Premium is the intercept term for the characteristic line. Market Risk Premium is the value on the vertical (y) axis where the characteristic line intersects. Beta represents the market effect on an asset’s return while Market risk premium represents the portion of the asset’s return that is affected by the asset’s inherent values, or its residual risks—above the risk free rate.

If alpha > 0, the positive value represents the extra return that an investor is rewarded for taking on risk beyond the market.
If alpha < 0, the negative value represents the return that was less than what the market itself performed.

Question 18

Systematic vs. Unsystematic Risk

Answer 18

Systematic risk is the market or nondiversifiable risk inherent in an asset or portfolio of assets. It is variability that cannot be eliminated through diversification.

Unsystematic risk is company-specific risk that is diversifiable and can be offset by investing in other firms with opposing unsystematic risk. For example, if you own shares in a ski resort that does well only in the winter months, you may want to also own shares in a beach resort that does well in the summer months when the ski resort is not doing as well.

Question 19

Correlation coefficient example

Answer 19

If Coca-Cola’s correlation coefficient is 0.785, then what portion of its risk during that period is nondiversifiable?

The nondiversifiable portion of the return would be R-squared or the correlation of coefficient squared. (0.785)² = 0.616 or 61.6%. Therefore, 61.6% of Coca-Cola’s total risk for that period can be attributed to the systematic risk, where risk is measured in terms of variance of return.

then 1 - 0.616 = 0.384 or 38.4%. That is, 38.4% of Coca-Cola’s total risk for that period is unsystematic risk (where risk is measured in terms of variance of return) and hence is diversifiable.