Course 3 Module 5: Investment Risks

Interest rate risk is defined as

"the risk of fluctuations in security prices due to changes in the market interest rate." Regardless of their source, interest rate changes can mean bad news for bond investors. Changes in interest rates affect the price of bonds inversely.

If a security has a beta of 0.6, how much will it move up or down on average as the market moves as a whole? +1.60% +60% +40% -0.60% +1.40%

+60%

A stock has an average (mean) return of 5.75% with a standard deviation of 7.59%. Within what range could an investor expect its return to fall 68% of the time? 7.59% to 13.34% -1.84% to 13.34% 1.84 to 13.34% 5.75% to 13.34%

-1.84% to 13.34% Mean = 5.75%SD = 7.59% 1σ = 5.75% - 7.59% = -1.84% 1σ = 5.75% + 7.59% = 13.34%

The normal distribution has the following characteristics:

-Its shape is perfectly symmetrical. -Its mean and median are equal. -It is completely described by two parameters - its mean and variance. -The probability of a return greater than the mean is 50%. -The probability of a return less than its mean is 50%. -There is approximately a 68% probability that the actual return will lie within + / - one standard deviation from the mean. -There is approximately a 95% probability that the actual return will lie within + / - two standard deviations from the mean. -There is approximately a 99% probability that the actual return will lie within + / - three standard deviations from the mean.

If a fund has a beta of 2.4 in relation to the S&P 500, how much would the fund be expected to move if the S&P 500 decreased by 10%? Lose 76% Lose 14% Lose 10% Lose 4% Lose 24%

10% x 2.4 = 24%

If a fund has a beta of 1.05 in relation to the S&P 500, how much would the fund be expected to increase if the S&P 500 increased by 15%? 22.5% 15% 14.25% 15.75%

15% x 1.05 = 15.75%

Stock ABC has an average (mean) return of 16% with a standard deviation of 16%. Within what range could an investor expect a return to fall 68% of the time? -16% to 32% 0% to 16% 0% to 32% 32% 16% to 32%

16% ± 16%

Which of the following statements are true? (Select all that apply) A stock with beta of 0.7 is an aggressive stock. A stock with R-squared of 70% has a return that was mostly caused by systematic risk. A stock with alpha of .04 had a better return than the market. A stock with R-squared of .7 is less correlated to the market than a stock with R-squared of .5. A stock with beta of 1.3 is a defensive stock.

2 and 3 R-square represents the portion of return attributed to undiversifiable or systematic risk. Positive alpha values represent a better return than market, while negative ones denote that the market performed better. If beta is greater than 1, then the stock is aggressive and if it is less than 1, then the stock is defensive. The closer to 1 R-squared is, the more correlated to the market it is.

Why would a company call its outstanding bond issues? Interest rates are rising Inflation rates are rising Interest rates are decreasing Exchanging rates are decreasing

3. Interest rates are decreasing When interest rates decrease, it gives a company incentive to exercise its right to call its outstanding bonds and issue new bonds in the current interest environment. This helps to lower the interest expense for the company and allow it to use the money on other things. Therefore when interest rates rise, companies would not call its debt because its existing interest expense is lower than current rates. Inflation and exchange rates have no direct relationship with the decision to call a bond issue.

If an asset's distribution has excess kurtosis greater than 0, and is also positively skewed, then the distribution is skewed to the left and will have fat tails the distribution is skewed to the right and will have thin tails the distribution is skewed to the left and will have thin tails the distribution is skewed to the right and will have fat tails

4 A positively skewed distribution is skewed to the right and a negatively skewed distribution is skewed to the left. Excess kurtosis greater than 0 describes a Leptokurtic distribution and will have fat tails.

If Coca-Cola's correlation coefficient is 0.785, what portion of its risk during that period is nondiversifiable? 0.616 0.215 0.384 0.785

A The nondiversifiable portion would be the R2 or the correlation coefficient-squared (0.785)2 = 0.616, or 61.6%. Therefore, 61.6% of Coca-Cola's return for that period is based on the, nondiversifiable, systematic risk.

Define mesokurtic

A normal distribution is called mesokurtic (meso is from the Greek word for middle).

A stock has an average (mean) return of 5.75% with a standard deviation of 7.59%. Within what range could an investor expect its return to fall 95% of the time? 1.84 to 13.34% -9.43% to 20.93% -1.84% to 13.34% -7.59% to 18.89%

Mean = 5.75%SD = 7.59% 2σ = 5.75% - (7.59% + 7.59%) = -9.43% 2σ = 5.75% + (7.59% + 7.59%) = 20.93%

Which of the following are examples of business risk? Click all that apply. A. Change the manufacturer process B. Reinvestment C. Inflation D. CEO charged with unethical business practices E. Interest rates F. Leverage buy out

A, D, F Business specific risks are uniquely associated with the company or entity issuing the security. Change is processes may increase short-term expenses but improve a company's efficiency in production in the lon-term. A company being bought out can be beneficial (company is broken up and sold in pieces). Charges for any illegal activities or business practices can be detrimental for the company's stock.

Which of the following investments has the highest standard deviation? Year 1 - stock 1 (ROR) = 10% -- stock 2 (ROR) = 8% Year 2 - stock 1 (ROR) = 6% -- stock 2 (ROR) = 12% Year 3 - stock 1 (ROR) = 12% -- stock 2 (ROR) = 16% Year 4 - stock 1 (ROR) = -5% -- stock 2 (ROR) = -8 Stock 1 or stock 2?

ANSWER = stock 2 calculator keystrokes 8 Σ + 12 Σ + 16 Σ + 8 CHS Σ + g key, x̄ (0 key) g key, S (. key) Stock #1 has a mean of 5.75% and a standard deviation 7.59%.

Inflation Risk

Another source of systematic (nondiversifiable) risk is inflation. Inflation risk reflects the likelihood that rising prices will eat away the purchasing power of your money.

The most likely asset class containing tax risk is:

Any type of pooled investment. In particular, mutual funds - by their very nature, contain considerable tax risk. The unrealized capital appreciation of many mutual funds represents a certain tax liability. To make matters worse, the new investors of a fund with significant unrealized capital gains will necessarily subsidize the tax liability of the fund's long-term investors. Capital gains distributions will be distributed pro rata, based on the number of shares held. Another example of tax risk for mutual funds is a simple dividend distribution. If you know that a fund will be trading ex-dividend in two days, you would not buy the fund today. If you did, you would be essentially "buying" a tax liability. Even if you held the fund for a month prior to an annual dividend distribution, you are subsidizing the shareholders tax liability that held the fund for the entire year prior to the annual distribution. The pro rata distribution is strictly based on the number of shares held, and is not sensitive to holding periods.

What is Investment Manager Risk?

Anytime an investor delegates investment management responsibility for their portfolio (or fraction there of) to an investment manger, the investor will be exposed to this risk. A subtle but good example of this risk is style drift. For example, an investor allocates a certain portion of their equity holdings to large-cap value stocks. In turn, the investor purchases ABC large-cap value fund. Over the course of the year, ABC's fund manager, feeling pressure to enhance the fund's returns, begins purchasing small-cap growth stocks. The investor, without even being aware of it, has now drifted outside the designed allocation parameters for the equity portion of their portfolio.

Financial Risk

Associated with the use of debt by firms

Call (Prepayment) Risk

Call risk is the risk to bondholders that a bond may be called away before maturity. "Calling" a bond refers to redeeming the bond early. Many bonds are callable. When a bond is called, the bondholder generally receives the face value of the bond plus one year of interest payments. This risk applies only to investments in callable bonds.

Business Risk

Can be caused by management decisions

Which of the following is used to measure an investment's beta and residual variance? Characteristic line Standard Deviation Undiversifiable risk Correlation coefficient

Characteristic line The characteristic line is a simple linear regression used to measure an investment's beta and residual variance. The standard deviation is the square root of the variance. Undiversifiable risk is that portion of a stock's risk or variability that cannot be eliminated through diversification. The correlation coefficient is a goodness-of-fit statistic that measures how well the data points fit a regression line.

Which of the following terms refers to the weighted average of all the different rates of return in one probability distribution? Alpha Beta Expected rate of return Systematic risk

Expected rate of return The expected rate of return is defined as the weighted average of various rates of return in one probability distribution. Alpha is the value on the vertical axis where the characteristic line intersects that axis, while beta measures the slope of one asset's characteristic line. Systematic risk is that portion of a stock's risk that cannot be eliminated through diversification.

Market risk results only from fluctuations in security prices due to changes in the market interest rate. T or F

F. Market risk is associated with overall market movements, not just changes in interest rate. The interest rate risk is, in fact, associated specifically with changes in the market interest rate.

The correlation is also a goodness-of-fit statistic that measures how well the data points fit a regression line:

If the asset and the market returns are perfectly positively correlated, p = 1 and all the data points lay on a positively sloped regression line. Simply put, the asset and the market will move in the exact same direction to the exact same level at the exact same time. If the two returns are perfectly negatively correlated when p = -1 and all the data points lay on a negatively sloped regression line. Simply put, the asset and the market will move in the exact opposite direction to the exact same level at the exact same time. If p = zero, the dependent and the explanatory variables are uncorrelated. Two variables that are uncorrelated do not co-vary together. They are statistically independent of each other and you will not be able to predict the movement of one through the movement of the other.

Liquidity Risk

Inability to find a buyer at a fair market price

What is Sovereign Risk?

Investors in a foreign country should evaluate the possibility that the foreign country's government could collapse, its legal system could be inadequate or corrupt, its police force may not be able to maintain order, the settlement process for securities transactions breaks down occasionally, or other problems arise.

How is prepayment risk similar to call risk?

It refers to mortgage payers paying off their mortgage early. A common practice for this is when interest rates are low and homeowners refinance their homes at lower rates. This causes debt instruments made of mortgages such as GNMAs to accelerate the amount of principal returned to the investor. Again, the investor receives his or her original investment earlier than anticipated and at a time when the interest rates are lower. Call risk and prepayment risk overlap with reinvestment risk. Instead of the investor selling early or purchasing instruments that mature before their investment time horizon, this is a case of the investor being forced out of their position prematurely during their holding period.

What is kurtosis?

Kurtosis is a statistical measure that tells us when a distribution is more or less peaked than a normal distribution. These distributions are measured by kurtosis. By definition, normal distributions have kurtosis equal to three. However, most statistical package 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.

Which of the following is not a source of systematic risk? Liquidity risk Exchange rate risk Market risk Purchasing power risk Interest rate risk

Liquidity risk

What is liquidity risk?

Liquidity risk deals with the inability to sell a security quickly and at a fair market price. The difference between liquidity and marketability is in the fair market price. 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. For investments that are infrequently traded, such as the stocks of small companies, it can be hard to find a buyer. Sometimes it's impossible to find a buyer at a fair market price, and you wind up having to sell for less than the asset's worth - sometimes even for a loss.

What is business risk?

Most stocks and corporate bonds are influenced by how well or poorly the company that issued them is performing. Business risk deals with fluctuations in investment value that are caused by good or bad management decisions, or how well or poorly the firm's products are doing in the marketplace. Businesses can go bankrupt, and management can make poor decisions. A CEO's decision to leave a company, or a company's decision to lay off part of their staff, may cause the share price of the company's stock to rise or fall depending on the impact of the decision on the company's performance.

What is Political and Regulatory Risk?

Political and regulatory risk results from unanticipated changes in the tax or legal environments that have been imposed by the government. A company may have to spend a large amount of money in order to comply with new regulations. On the upside, changes in federal or state tax laws may lead to more deductions for a company or for individual taxpayers. Regulatory risks may be unsystematic (diversifiable) depending on the size and scope of the regulation change. Tax law changes may affect all investors. Changes in environment laws such as hazardous waste disposal would only affect those companies that dispose hazardous waste.

U.S. Treasury securities are subject to which of the following risks? Credit Risk Purchasing Power Risk Marketability Risk Default Risk

Purchasing Power Risk At this time very little credit, marketability, and default risk exists.

Why is interpretation of standard deviation most important.?

Standard deviation is a measure of variability; that is, how much your actual return will vary from what you expect.

Sovereign Risk

Subject to foreign country seizing investment

nondiversifiable risk (systematic risk)

Systematic or nondiversifiable risk is that portion of a stock's risk or variability that cannot be eliminated through diversification. It results from factors that affect all stocks. In fact, the term "systematic" comes from the fact that this type of risk systematically affects all stocks, i.e. it is of the system. Some sources of risk that maybe considered as systematic include market risk, interest rate risk, inflation risk, reinvestment risk, and exchange risk. The percentage of total risk that is nondiversifiable can be measured by the coefficient of determination or R-squared.

A portfolio with a beta of +1 has which of the following? Unsystematic risk No risk Systematic risk Both systematic and unsystematic risk

Systematic risk A portfolio with a beta of +1 is one that moves in the same direction and at the same rate as the market. Therefore the portfolio only has market risk which is also known as systematic risk.

François, a wholesaler for Les Bleus Funds, visits your office and presents two investment alternatives. Lamarck Fund: R2 = 0.24, ß = 1.60 Montaigne Fund: R2 = 0.89, ß = 1.04 Which of these investments is more likely to provide returns that outperform the market during an expansion? Lamarck Fund Montaigne Fund

The Montaigne Fund is more likely to outperform the market during an expansion. With an R2 of 0.24, Lamarck Fund's Beta is not reliable. As a result, the Montaigne Fund is more likely to outperform the market due to its reliable R2 of 0.89, and a Beta of 1.04 that suggests that it will outperform the market.

At the beginning of the year, one U.S. dollar could buy 80 Japanese yen. At the end of the year, one U.S. dollar could buy 100 Japanese yen. What happened to the U.S. dollar during the year? The U.S. dollar was revalued. The U.S. dollar was devalued. The U.S. dollar was inflated. The U.S. dollar was deflated.

The U.S. dollar was revalued. By definition, the U.S. dollar was revalued. Revaluation refers to an increase in the currency's value.

What is the beta coefficient?

The beta coefficient is an index of undiversifiable (market, systematic) risk. You can rank betas from different assets to compare the undiversifiable risk of the assets. Since the beta of the market (Bm) equals 1, if the beta of the investment (Bi)= 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 poorly, it will do less poorly than the market.

risk premium

The compensation that investors demand for taking on added risk

Correlation Coefficient

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.

Coefficient of Determination

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's 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. The closer to one that an asset's R-squared value is, the more reliable its beta. if an asset's R-squared is below .7, then Beta and everything that uses Beta (like the Treynor ratio and Jensen's Alpha) would be a meaningless statistic.

Why would a company call their outstanding bond issues?

The current interest rates are lower than what the outstanding issue pays in coupon rates. Therefore, the company would lower its interest payable by calling its bonds and issuing new ones at lower coupon rates. The risk for the investor is that once they receive the bond's par value, they must now invest it in an environment of lower interest rates for the remainder of their investment time horizon.

What does the value of an asset's variance, or the wideness of the probability distribution represent? Additional risk that is firm specific Undiversifiable risk that is market related How closely two assets move together The degree of risk associated with asset

The degree of risk associated with asset Variance represents the amount of risk associated with an asset. The higher the value (the wider the distribution) the more likely the actual return will vary from the expected return. Covariance describes the relationship between two or more assets. The characteristic line identifies the diversifiable and undiversifiable risks.

Lognormal Distribution

The lognormal distribution is closely related to a normal distribution. Like the normal distribution, the lognormal distribution is completely described by two parameters. These again, are the mean and variance. However, in the case of the lognormal distribution, the mean and the variance are of its associated normal distribution. In other words, in the real world we not only must track the mean and variance of the data set, we must also track the mean and variance of the data set's distribution! A key distinguishing feature of this distribution is that zero in the lower tail will always bound it, and the distribution itself will always be positively skewed.

Normal Distribution

The symmetrical, bell-shaped distribution known as a normal distribution plays the center role in the mean-variance model of portfolio selection. The normal probability distribution is also used extensively in financial risk management.

What is reinvestment risk?

This type of risk refers to the inability of the investor to know the interest rate at which the proceeds from a maturing investment can be reinvested for the remainder of its holding period. For example, if an investor with a six-month holding period buys a 90-day T-bill, he or she is taking on the risk that interest rates available in 90 days may be less than what he or she is currently getting.

Exchange Rate Risk

This type of risk refers to the variability in earnings resulting from changes in exchange rates. For example, if you invest in a German bond, you first convert your dollars into German euros. When you liquidate that investment, you sell your bond for German euros and convert those euros into dollars. What you earn on your investment depends on how well the investment performed and what happened to the exchange rate. For the international investor, exchange rate risk is simply another layer of risk.

By rearranging the characteristic line, you can attribute the returns that are diversifiable vs. nondiversifiable. Total Return formula

Undiversifiable + Diversifiable = Total Return of Period for Asset

An investment's total risk, measured by its variance of returns, can be partitioned into two components:

Unsystematic or Diversifiable risk Systematic or Nondiversifiable risk

Diversifiable Risk (Unsystematic)

Unsystematic or diversifiable risk is risk or variability that can be eliminated through diversification. It results from factors unique to a particular stock. Statisticians call the diversifiable risk, VAR(e), the residual variance, or the standard error squared. Diversifiable risk is made up of idiosyncratic fluctuations that are unique to the investment. Some sources of unsystematic risk include business risk, financial risk, default or credit risk, regulation risk and sovereignty risk. The percentage of total risk that is diversifiable can be measured by subtracting the coefficient of determination or R-squared from one.

The risk quantified by standard deviation is which of the following? Variability Nondiversified portfolio Total risk Volatility Diversified portfolio

Variability Nondiversified portfolio Total risk

The risk level quantification of beta is which of the following? Volatility Systematic risk Non-systematic risk Unsystematic risk Total risk

Volatility Systematic risk

The variance of an asset's rates of return is

a statistic that measures the asset's wideness. The variance is represented by the symbols s2 and VAR(r).

unsystematic

diversifiable / company or industry specific risks

Investment manager risk is asset-specific and therefore is considered to be a

diversifiable, unsystematic risk

Unsystematic risk

is a 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. Business Risk Financial Risk Credit (Default) Risk Regulation Risk Sovereignty Risk

Market Risk

is associated with overall market movements. There tend to be periods of bull markets, when most stocks seem to move upward; and times of bear markets, when most stocks tend to decline in price. The same tends to be true in the bond markets. These periods may be a result of changes in the economy, changes in the mood of investors, or changes in interest rates. Market risk and interest rate risk are examples of overlap in sources of risk. Market risk is synonymous with systematic risk or nondiversifiable risk. Market risk is measured by beta and is expressed as having a beta of one.

Financial Risk

is associated with the use of debt by firms. As a firm takes on more debt, it also takes on interest and principal payments that must be made regardless of the firm's performance. If the firm can't make the payments, it could go bankrupt. Thus, how a firm raises money affects its level of risk. Financial risks are specific to the company and therefore are unsystematic (diversifiable).

Tax Risk

is defined as the investor being burdened with an unexpected tax liability

Systematic risk

is the market or non-diversifiable risk inherent in an asset or portfolio of assets. It is the variability that cannot be eliminated through diversification. Purchasing Power Risk (Inflation Risk) Reinvestment Rate Risk Interest Rate Risk Market Risk Exchange Rate Risk

A distribution that is more peaked than normal is called

leptokurtic (lepto is from the Greek word for slender)

A positively skewed distribution is characterized by

many outliers in the upper, or right tail. A positively skewed distribution is said to be skewed right because of its relatively long upper tail. Stock market returns for instance, exhibit a positively skewed distribution. This should be evident by the fact that there are many more positive return years than negative ones.

Co-Movement (Co-Variance)

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, co-variance considers the joint probability distribution of two random variables. That is, in a given state, the two random variables assume particular values. The joint probability distribution describes those pairs of values for each possible state and the probabilities of those outcomes occurring.

systematic

nondiversifiable risks / market risks

A negatively skewed distribution has many

outliers that fall within its lower, or left tail. This type of distribution is said to be skewed left.

A distribution that is less peaked than normal is called

platykurtic (platy is from the Greek word for broad)

The standard deviation equals the

square root of the variance. It measures the degree to which the asset may vary from the mean (the expected return) of the probability distribution of returns. The greater the degree of dispersion from the mean (expected return) equals the greater the degree of risk.

interest rate risk is a type of systematic or unsystematic risk?

systematic (nondiversifiable)

Skewness refers to

the extent to which a distribution is not symmetrical. We only use the normal distribution, with its symmetrical bell-shape for simplicity reasons.

Semi-variance focuses only on

the half of the variance that refers to the asset performing below the expected return or average return. The recent use of semi-variance may be driven by the fact that over the years, many investors have become accustomed to think of risk only as downside risk.

What is alpha?

the value on the vertical axis where the characteristic line intersects that axis

Political and Regulatory Risk is a type of systematic or unsystematic risk?

unsystematic (diversifiable) depending on the size and scope of the regulation change

Liquidity Risk is a type of systematic or unsystematic risk?

unsystematic and can be diversified

Business risk is a type of systematic or unsystematic risk?

unsystematic, or diversifiable risk.

Over long periods of time, common stocks have produced a return:

well above the rate of inflation, thereby preserving the purchasing power of your money