Module 3: Investment Risks

Systematic risks:

• nondiversifiable risks / market risks • affect all investments.

Sovereign Risk

• A 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.

The Characteristic Line

• Beta and the residual variance are risk statistics that measure an investment's systematic (undiversifiable) and unsystematic (diversifiable) risks. • A simple linear regression called the characteristic line 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).

Which of the following are required to estimate risk?

• Correlation coefficient, • Variance of an asset's rates of return, • Coefficient of determination, • Standard deviation

The correlation coefficient

• If the asset and the market returns are perfectly positively correlated, p = 1 • If the two returns are perfectly inversely correlated when p = -1 • The correlation between the typical NYSE stock and the NYSE index is 0.50.

The normal probability 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%.

Risk Estimates

• Risk is equated with variability of return, or the likelihood of the asset to deviate from the expected return. • Financial risk management uses tools such as Value at Risk (VAR) and downside risk to access the probability of returns being less than some predetermined amount.

Nondiversifiable Risk (Systematic)

• 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.

Systematic vs. Unsystematic Risk

• The only risk you will get compensated for taking is systematic risk, because unsystematic risk can be eliminated through diversification. In effect, unsystematic risk does not exist for diversified investors. • The market does not compensate investors for taking on risk they can eliminate for free

alpha

• an estimate of the asset's rate of return when the market is stationary. • Beta represents the market effect on an asset's return while alpha represents the portion of the asset's return that is affected by the asset's inherent values, or its residual risks. • In a portfolio, the alpha represents the free return from the performance above the market or the value added by the portfolio manager • 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.

Financial risk

• 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. • how a firm raises money affects its level of risk. • Financial risks are specific to the company and therefore are unsystematic (diversifiable).

Interest rate risk:

• because increases in interest rates affect all securities in the same way, it's impossible to eliminate interest rate risk. • Therefore, interest rate risk is a type of systematic (nondiversifiable) risk

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. • specific to the stock or bond that the business issues. • is a type of unsystematic, or diversifiable risk. • The downside of business risk can be limited through diversification.

unsystematic risks:

• diversifiable / company or industry specific risks • specific to the security or the security's industry. • the sources of risks are not mutually exclusive - that is, there is a good deal of overlap between them.

An investment's total risk consists of two components:

• diversifiable risk • nondiversifiable risk

Semi-variance

• focuses only on the half of the variance that refers to the asset performing below the expected return or average return

standard deviation

• is a measure of variability; that is, how much your actual return will vary from what you expect • implicit in a standard deviation statistic, is a holding period of one year

the characteristic line

• is a simple linear regression used to measure an investment's beta and residual variance. • It identifies the diversifiable and undiversifiable risks

Kurtosis

• is a statistical measure that tells us when a distribution is more or less peaked than a normal distribution

The beta coefficient

• is an index of undiversifiable (market, systematic) risk. • 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 • If Bi < 1, then the asset is a defensive asset. Its rates of return are less volatile than the market's

Investment Manager Risk:

• is asset-specific and therefore is considered to be a diversifiable, nonsystematic risk. • pooled investments, by their nature, are where this risk is most acute. • 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

Market risk

• is associated with overall market movements • Market risk and interest rate risk are examples of overlap in sources of risk. • is synonymous with systematic risk or nondiversifiable risk • is measured by beta and is expressed as having a beta of one.

expected rate of return

• is defined as the weighted average of various rates of return in one probability distribution

Unsystematic or diversifiable risk

• is risk or variability that can be eliminated through diversification. • It results from factors unique to a particular stock. • 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.

Call (Prepayment) Risk

• is the risk to bondholders that a bond may be called away before maturity. • current interest rates may be lower than what the outstanding issue pays in coupon rates. The company could 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. • Prepayment risk is similar to call risk in that it refers to mortgage payers paying off their mortgage early. Call risk and prepayment risk overlap with reinvestment risk

coefficient of determination

• measures the portion of the asset's performance that can be attributed to the returns of the overall market • 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.

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. • Co-variance can be used to look at the relationship of two or more assets and how closely they move together. • You can use it to solve for the correlation coefficient. • Positive values mean that the two assets' prices tend to move in the same direction • Negative values would indicate the assets behave inversely.

Inflation Risk:

• nondiversifiable • reflects the likelihood that rising prices will eat away the purchasing power of your money. • especially present in long-term bonds • 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.

Skewness

• refers to the extent to which a distribution is not symmetrical. • 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. • 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

Reinvestment 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

variance

• represents the amount of risk associated with an asset

Political and regulatory risk

• results from unanticipated changes in the tax or legal environments that have been imposed by the government. • Regulatory risks may be unsystematic (diversifiable) depending on the size and scope of the regulation change

R-squared

• the closer to 1 r-squared is, the more correlated to the market it is • represents the portion of return attributed to undiversifiable or systematic risk

Liquidity Risk

• 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 • assets with great liquidity risks would not be appropriate for emergency funds

Tax risk

• the investor being burdened with an unexpected tax liability. • This risk is considered to be a diversifiable, unsystematic risk due to the fact that this risk is borne in asset-specific situations. • By far, the most likely asset class containing tax risk is any type of pooled investment. In particular, mutual funds. I • 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.