Flashcards in Section 103 Unit 5 Deck (34):
Investment risk is the uncertainty that an investment’s actual, or realized, return will be different from its expected return.
Expected return is the return that the investor demands or expects to make and is computed by multiplying each of the investment’s possible annual returns by the probability that they will occur and adding the results.
Total or Absolute Risk
Unsystematic, or diversifiable, risk
Systematic, or nondiversifiable, risk
total risk = unsystematic risk + systematic risk
Total risk may be quantified, or measured, by standard deviation, whereas systematic risk may be measured by an investment or portfolio’s beta coefficient, or beta. Because unsystematic risk may be effectively managed by the construction of a diversified portfolio, the risk with which the investor should be most concerned is systematic risk.
Unsystematic risk, also known as diversifiable risk, is risk that affects only a particular company, country, or sector and its securities. This risk is not correlated with stock market returns.
Business risk is the uncertainty of operating income. (Unsystematic risk)
Financial risk is the risk that a firm’s financial structure will negatively affect the value of an equity investment. (Unsystematic risk)
Liquidity risk is also a type of unsystematic risk. Recall, liquidity is the ability to sell an asset quickly and without significant loss of principal. (Unsystematic risk)
Default risk is the potential inability of a debt issuer to make timely interest and principal repayments. Junk bonds are particularly subject to default risk. An investment in common stock is not subject to default risk because the issuing corporation is not contractually bound to pay dividends. (Unsystematic risk)
Political risk is the risk that the political and economic climate of a country will negatively affect an investment. Governments have the power to change laws affecting securities. (Unsystematic risk)
Tax risk is the uncertainty associated with a country’s tax laws that may potentially affect the rate of return generated by an investment. (Unsystematic risk)
Investment Manager Risk
Investment manager risk is the risk associated with the skills and philosophy of the individual manager of an investment fund or account. (Unsystematic risk)
Systematic risk reflects the uncertainty of returns associated with an investment in any type of asset. This part of risk is generally considered inescapable, because the risk of the overall investment market may not be completely avoided. Therefore, a portfolio manager hopes to minimize systematic risk.
The five basic sources of systematic risk are:
Purchasing power (inflation) risk
Reinvestment rate risk
Interest rate risk
Exchange rate (currency) risk
To memorize the components of systematic risk, remember the mnemonic PRIME, which uses the first letter of each risk source.
Purchasing Power Risk
Purchasing power risk is the potential loss of the purchasing power of an investment due to inflation. (Systematic Risk)
Reinvestment Rate Risk
Reinvestment rate risk is the risk that proceeds available for reinvestment must be reinvested at a lower rate of return than that of the investment vehicle that generated the proceeds.
Reinvestment rate risk mostly affects fixed income types of investments, particularly those with long-term maturities in a changing interest rate environment.
A way to eliminate reinvestment rate risk is to invest in zero-coupon bonds.
Interest Rate Risk
Interest rate risk is the risk that the market price of an investment will decline as the result of changes in market interest rates. The most notable investment that is subject to interest rate risk is bonds, whose market prices move inversely with market interest rates. (Systematic Risk)
Market risk is the risk of the overall securities marketplace. The more volatile the movement of a security’s return (as measured by beta), the greater its risk in comparison to a market index, such as the Standard and Poor's 500 index. (Systematic Risk)
Exchange Rate Risk
Exchange rate risk is the risk that a change in the relationship between the value of the dollar and the value of the foreign currency during the period of investment will negatively affect the investor’s return. (Systematic Risk)
Standard deviation is an absolute measure of the variability of the actual investment returns around the average or mean of those returns (otherwise known as the expected return of the investment).
Formula for the sample standard deviation and Population Standard Deviation of an asset
X is increasing amount of years. Y is the actual rates of return for the past years.
Shift Sx, Sy
Beta is a relative measure of systematic risk. Beta may be used as a measure for the risk associated with a particular security or portfolio. Beta can be negative (gold).
The beta of a portfolio of securities is a weighted beta, meaning that the portfolio beta is calculated by weighting the individual asset betas and adding the results.
Find Weighted Beta
Times amount of money invested (FMV) in stock A by the beta of Stock A which equals Product and repeat for all stocks in the portfolio. Then, add all the FMV and the total of Product and divided the Product by the FMV equalling the Weighted Beta
Weighted Average Return
The weighted average return represents the return for a portfolio, where each return is weighted by the proportion of the security to the entire portfolio
Semivariance is a measure that focuses on the downside risk of an expected return and is described as the average square deviation below the mean. When used in analysis, the lower the semivariance of a security, the less likely the security will incur a substantial loss in value. The statistical measure of semivariance only measures those returns below the mean. Semivariance was developed because the primary consideration of the risk-averse investor is downside risk.
Covariance measures the extent to which two variables (the returns on investment assets) move together, either positively (together) or negatively (opposite). For example, if there is a negative covariance between assets, this implies that when one asset has a positive return, the other asset has a negative return.
We know that if the covariance between two assets is negative, so is the correlation coefficient.
perfectly positively correlated assets have a correlation coefficient of +1.0 (in this event, the assets move exactly together and there is no reduction in the total risk of the portfolio);
perfectly negatively correlated assets have a correlation coefficient of –1.0 (in this event, the assets move exactly opposite of one another and the total risk of the portfolio can be completely eliminated); and
a correlation coefficient of 0.0 means there is no relationship between the returns of the assets.
Standard Deviation (stock 1) x Standard Deviation (stock 2) x correlation coefficient = Covariance
Correlation Coefficient Formula
Covariance / ( Standard Deviation (stock 1) x Standard Deviation (stock 2) ) = Correlation Coefficient
Coefficient of Determination Formula
Squaring the correlation coefficient, we can compute the coefficient of determination.
Coefficient of Determination
Describes the percentage of variability in one variable (e.g., a stock) that is explained by the changes in a second variable (e.g., the overall market) or the strength of the relationship between the two variables. For example, if the coefficient of determination between ABC stock and the market is 70% (0.70), then 70% of ABC’s movement in price may be explained by changes affecting the overall market. The remaining 30% (0.30) of price movement is explained by changes that do not affect the overall market, or unsystematic risk.
Jensen and Treynor methods
The Jensen and Treynor methods use beta as the relevant risk measure; therefore, by definition, each method assumes a diversified portfolio with little unsystematic risk. Thus, the use of Jensen and Treynor is appropriate only where the R2 of the stock or portfolio is approximately 0.75 or more.
The Sharpe Method
Sharpe method uses standard deviation as the relevant risk measure and, therefore, may be used to evaluate any portfolio or stock. Thus, the use of the Sharpe method is required where the R2 of the stock or portfolio is less than 0.75, but the Sharpe method may be used with any R2.
Normal Probability Distribution
68% of the returns fall within 1 standard deviation of the mean, 95% within 2 standard deviations, and 99% within 3 standard deviations. Therefore, if the mean is 9% there is a less than 1% chance there will be a negative return.