P2B.1 Risk & Return

Question 1

Risk Definition

Answer 1

1. Risk is the chance that an outcome will differ from an expected outcome or return.
2. Can be measured using statistical tools such as variance and standard deviation.

Question 2

Business Risk

Answer 2

Major uncertainties in the economy and how projects might be affected by these uncertainties.

1. Degree of operating leverage
2. Variability in consumer demand
3. Price variability
4. Impact of inflation on input prices

Question 3

Systematic Risk

Answer 3

1. Attributable to the market, undiversifiable and can’t be predicted or avoided.
2. Includes interest rate risks, inflation, war and recession.
3. Measured by the covariance between security’s return and market.

Question 4

Unsystematic Risk

Answer 4

1. Attributable specifically to a company, unique, diversifiable and avoidable.
2. No correlation between these risks and market wide factors.
3. Can be reduced by diversifying the investment.
4. Includes poor management decisions, labor strikes and industry regulation changes.

Question 5

Credit Risk

Answer 5

Risk of loss due to inability to repay a loan or failure to adhere to debt agreements.

Question 6

Foreign Exchange Risk

Answer 6

Risk that particular currency loses its value relative to another currency.

Question 7

Interest Rate Risk

Answer 7

Risk that a change in market interest rates can significantly reduce value of an investment.

Question 8

Market Risk

Answer 8

Risk that value of an investment will change because overall market performance.

Question 9

Industry Risk

Answer 9

Risk that the industry’s performance may negatively affect the investment of a company.

Question 10

Political Risk

Answer 10

Risk that political actions and government rules and regulations will affect the performance of an entity and its investments.

Question 11

Value at Risk (VaR)

Answer 11

The maximum loss within a given period of time and given a specified probability level (level of confidence).

Question 12

Rate of Return

Answer 12

1. Rate at which an asset or capital generates income.
2. Calculated on an annual basis.
3. The greater the risk, the greater the potential return.

Question 13

Rate of Return Formula

Answer 13

= Income / Average Investment Income

Question 14

Relationship between Risk & Return

Answer 14

1. Directly related; strong positive relationship.
2. High risk, high return: stocks
3. Low risk, low return: government bonds and treasury notes.

Question 15

Standard Deviation

Answer 15

Statistical measure of variability or tightness of a distribution of outcomes around a central measure, the expected return.

Question 16

Coefficient of Variance (CV)

Answer 16

Measures the relative risk per expected return.

= Standard deviation / Expected return

Question 17

Diversification

Answer 17

1. Can’t eliminate risk, but can reduce it.
2. Replaces individual risk with a number of different risks.
3. Gains can help offset losses (variances)

Question 18

Capital Asset Pricing Model (CAPM)

Answer 18

1. Financial model used in calculating the expected risk-adjusted returns.
2. Based on time value of money concept and risk (risk free rate and beta)

Question 19

Capital Asset Pricing Model (CAPM) Formula

Answer 19

R = RF + β(RM − RF )

R = Expected return
RF = Risk free rate of return
RM = Market Rate
(RM − RF ) = Market risk premium
β = Beta coefficient, systematic (undiversifiable) risk

Question 20

Beta Analysis

Answer 20

1. Measure of individual stock volatility.
2. Debt to equity ratio, industry characteristics and operating leverage will have impact on beta.

β > 1 High risk multiplier of stock price, highly volatile
β < 1 Low risk multiplier of stock price, less volatile
β = 1 Market & stock price move perfectly to changes in market
β = 0 No correlation of stock & market price
β < 0 Stock price moves inversely with that of the entire market

Question 21

Yield Curve

Answer 21

Plots the interest rate of bonds that have equal credit quality at a set period of time, but differing maturity dates.

Question 22

What are the three main patterns created by the interest rate term structure?

Answer 22

1. Normal yield curve—this forms during normal market conditions.
2. Flat yield curve—this forms when the market is sending mixed messages to investors.
3. Inverted yield curve—this forms during extraordinary market conditions.

Question 23

Common measures of Risk

Answer 23

Individual: expected return & standard deviation

Portfolio: covariance & correlation

Question 24

Correlation

Answer 24

Statistical measure of the degree in which two investments move in relationship to each other.