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ITF Chapter 2 Flashcards

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1
Q

What is the primary task of a financial planner regarding investments?

A

To identify and measure the risk of investments.

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2
Q

Why is it important to measure the degree of risk in an investment?

A

Investors demand to be adequately compensated for bearing risk.

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3
Q

What does the term ‘risk’ refer to in finance?

A

The chance that some unfavourable event will occur.

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4
Q

What are the two ways to consider the riskiness of an asset?

A
  • On a stand-alone basis
  • In a portfolio context
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5
Q

What is the definition of business risk?

A

The uncertainty of cash inflows caused by the nature of a firm’s business.

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6
Q

What is financial risk also known as?

A

Default risk.

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7
Q

What does liquidity risk refer to?

A

The uncertainty introduced by the secondary market for an asset.

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8
Q

True or False: Cash is considered the most liquid of all assets.

A

True.

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9
Q

What is exchange rate risk?

A

The uncertainty of returns to an investor who acquires securities in a foreign currency.

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10
Q

What is country risk also called?

A

Political risk.

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11
Q

What is inflation risk commonly referred to as?

A

Purchasing power risk.

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12
Q

Fill in the blank: The Fisher equation depicts the relationship between the nominal rate, inflation, and the _______.

A

[real rate]

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13
Q

How can the real rate be approximated?

A

By subtracting the expected inflation rate from the nominal rate.

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14
Q

What is interest rate risk?

A

The risk arising from unexpected changes in interest rates.

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15
Q

What formula represents the required rate of return?

A

Required rate of return = nominal risk-free rate + risk premium.

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16
Q

What is the implication of a higher level of debt for a firm?

A

Higher debt servicing costs and increased financial risk.

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17
Q

What is the effect of inflation on the real value of money?

A

The real value of money declines when prices rise.

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18
Q

What happens to the real rate of return when inflation increases?

A

It reduces the real rate of return on the investment.

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19
Q

How does liquidity risk affect investment returns?

A

Investors demand higher required returns to compensate for liquidity risk.

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20
Q

What does the Fisher Equation account for?

A

The relationship between nominal rate, real rate, and expected inflation rate.

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21
Q

What is the real rate of return using the Fisher equation when the nominal rate is 5% and inflation is 2%?

A

2.94%

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22
Q

What is the effect of a marginal tax rate on the after-tax nominal rate?

A

It reduces the nominal rate based on the tax rate applied.

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23
Q

What happens to an 8% bond if market interest rates increase to 10%?

A

The price of the 8% bond will fall due to lower attractiveness compared to new bonds.

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24
Q

What happens to bond prices when interest rates rise?

A

Bond prices fall

This is due to interest rate risk, where existing bonds with lower coupon rates become less attractive compared to new bonds with higher rates.

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25
Define market risk.
Risk derived from the economy as a whole ## Footnote It encompasses uncertainties about general economic conditions and inflation rates affecting many assets.
26
What is standard deviation denoted by?
σ (sigma) ## Footnote It measures the variability or volatility of data values.
27
What does a smaller standard deviation indicate?
Lower riskiness of the asset ## Footnote A smaller standard deviation means a tighter probability distribution of expected returns.
28
What is variance represented by?
σ² ## Footnote Variance is the square of the standard deviation and measures fluctuations in asset prices.
29
How is the standard deviation calculated?
By taking the square root of the variance ## Footnote It quantifies the likelihood that actual returns will be close to expected returns.
30
Fill-in-the-blank: The _______ is the largest data value minus the smallest data value.
Range ## Footnote The range is a simple measure of variability.
31
What is stand-alone risk?
Risk faced by an investor holding only one asset ## Footnote It is important to understand this to comprehend risk in a portfolio context.
32
What is the coefficient of variation (CV)?
Standard deviation divided by expected return ## Footnote It measures the risk per unit of return and is useful when expected returns differ.
33
True or False: Diversifiable risk can be eliminated through portfolio diversification.
True ## Footnote Diversifiable risk is non-systematic and can be mitigated by holding a diverse range of assets.
34
What does a correlation coefficient of +1 indicate?
Perfect positive correlation ## Footnote It means the two variables move together in the same direction.
35
What is the expected return formula for an investment with multiple outcomes?
Sum of (probability × return) for each outcome ## Footnote This calculation helps determine the average return expected from an investment.
36
What does a high standard deviation suggest about an asset's returns?
Higher risk and larger fluctuations ## Footnote Investors require higher returns to compensate for increased risk.
37
What is the significance of normal distribution in relation to standard deviation?
It allows interpretation of the likelihood of returns falling within certain ranges ## Footnote Approximately 68%, 95%, and 99.7% of returns lie within one, two, and three standard deviations from the mean, respectively.
38
What is the relationship between diversification and portfolio risk?
Diversification reduces portfolio risk ## Footnote By combining assets that do not move together, overall portfolio risk can be decreased.
39
What key concept does the term 'systematic risk' refer to?
Market risk that cannot be eliminated by diversification ## Footnote It reflects the risk of a general decline in the stock market.
40
What is the formula for calculating variance from expected values?
Sum of (probability × squared deviation) ## Footnote This calculation involves deviations of possible outcomes from the expected value.
41
What is the importance of the mean in standard deviation calculations?
It serves as the baseline for calculating deviations ## Footnote Each data point's deviation from the mean is essential for determining variance and standard deviation.
42
What does a lower coefficient of variation indicate?
Lower risk per unit of return ## Footnote Investors prefer investments with lower CV as they represent less risk for the given return.
43
What is the correlation coefficient?
A mathematical measure of the degree to which two variables move together.
44
What is the range of values for the correlation coefficient?
Between −1 and +1.
45
What does a positive correlation imply?
The two variables tend to move in the same direction.
46
What does a negative correlation imply?
The two variables move in opposite directions.
47
What does a correlation coefficient of zero indicate?
A change in one variable does not provide any information about the change in the other variable.
48
What does a correlation coefficient of +1 signify?
The two variables are perfectly positively correlated.
49
What does a correlation coefficient of −1 signify?
The two variables are perfectly negatively correlated.
50
What is the formula for the standard deviation of portfolio returns?
σP = √(xA²σ²A + xB²σ²B + 2xAxBrABσAσB)
51
What do the variables xA and xB represent in the portfolio standard deviation formula?
Fraction of total investment in Stock A and Stock B, respectively.
52
How is variance of return on Stock A represented?
σ²A.
53
What is the correlation coefficient between returns of Stocks A and B denoted as?
ρAB.
54
What is the significance of portfolio diversification?
It can decrease risk up to a point but cannot eliminate it.
55
What happens to portfolio risk as the correlation coefficient between assets decreases?
Portfolio risk decreases, providing greater diversification benefits
56
True or False: Portfolio risk can be reduced to zero through diversification.
False.
57
What are the two types of risk in a portfolio context?
* Unique risk * Market risk
58
What is market risk?
Risk that cannot be eliminated by diversification, stemming from macroeconomic factors.
59
What is unique risk?
Risk that can be eliminated by diversification, caused by microeconomic factors.
60
What is the relationship between the risk of a stock and its expected rate of return?
The higher the risk, the greater the expected rate of return.
61
What is the Fisher equation used to define?
The relationship between real rates, nominal rates, and the inflation rate.
62
What is the preferred measure of risk for an asset?
Standard deviation.
63
Why is standard deviation preferred over variance?
Variance has units that are difficult to interpret.
64
What percentage of data lies within +/- one standard deviation of the mean in a normal distribution?
About 68%.
65
What percentage of data lies within +/- two standard deviations of the mean in a normal distribution?
About 95%.
66
What percentage of data lies within +/- three standard deviations of the mean in a normal distribution?
Over 99%.
67
What is the impact of adding more stocks to a portfolio?
The riskiness of a portfolio decreases.
68
What type of risks are investors with diversified portfolios primarily concerned with?
Macroeconomic risks.
69
What is liquidity risk?
The risk of needing your money at a time when an investment is not liquid.
70
Fill in the blank: The risk of losing purchasing power due to inflation is a type of _______.
Inflation risk (Purchasing Power Risk).
71
What are the various sources of risk affecting investment returns?
Business risk Financial (default) risk Liquidity (marketability) risk Exchange rate (currency) risk Country (political) risk Inflation (purchasing power) risk Interest rate risk Market (systematic) risk
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