Investment Risks Flashcards
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.
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.
This risk is especially present in long-term bonds, wherein the par value paid - say twenty years down the road - will only provide a fraction of the purchasing power available today for an equivalent amount of money. For example, even at an average rate of 3% inflation over a twenty-year period, $1,000 received 20 years from now would only be worth $553 in today’s dollars.
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.
Tax Risk
Tax risk is defined as 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.
Investment Manager Risk
Investment manager risk is asset-specific and therefore is considered to be a diversifiable, nonsystematic risk. As with tax 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.
Financial Risk
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).
Consider what happens when someone applies for a mortgage. The lender would conduct an analysis of the applicant’s ability to make payments.
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.
Market 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.
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.
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.
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.
Characteristics of a Normal Distribution
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.
Positively Skewed Distribution
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.
Negatively Skewed Distribution
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.
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!
