FIN3244 Test 2 Study Guide 1 Risk Measures impact on return 18 10 2011 15 27 00 Standard Deviation an absolute measure of risk a statistic used to measure the dispersion variation of returns around an asset s average or expected return o Provides a quantitative tool for comparing investment risk o The larger the standard deviation the greater the absolute dispersion the riskier the investment o Of coarse these values are absolute measures based on historical data There is no assurance that the risks of these two will remain the same in the future Coefficient of Variation a relative measure of risk a statistic used to measure the relative dispersion of an asset s returns it is useful in comparing the risk of assets with differing average or expected returns o Coefficient of variation standard deviation average or expected return o The higher the coefficient of variation the greater the risk o The real utility of the coefficient of variation is in comparing investments that have different expected returns Historical Returns and Risk o A close relationship can be seen between the investment returns and the standard deviation and coefficients of variation Investments with higher returns have higher standard deviations and coefficients of variation Because higher standard deviations and coefficients of variation are associated with greater risk the historical data confirm that there is a positive relationship between risk and return Participants require higher returns as compensation for greater risks 2 Types of risk that pertain to an investment Sources of Risk o 1 Business risk the degree of uncertainty associated with an investment s earnings and the investment s ability to pay the returns interest principal dividends owed investors example business owners may receive no return if the firm s earnings are not adequate to meet obligations much of the business risk associated with a given investment vehicle is related to its kind of business example the amount of business risk in a public utility common stock differs from the amount in the common stock of a high fashion clothing manufacturer or an Internet start up generally investments in similar kinds of firms have similar business risk although differences in management costs and location can cause varying levels of risk o 2 Financial Risk the degree of uncertainty of payment resulting from a firm s mix of debt and equity the larger the proportion of debt used to finance a firm the greater its financial risk debt financing obligates the firm to make interest payments as well as to repay the debt thus increasing risk inability to meet debt obligations could result in business failure and in losses for bondholders as well as stockholders and owners o 3 Purchasing Power Risk chance that changing price levels inflation deflation will adversely affect investment returns rising prices will reduce purchasing power amount of a given commodity that can be purchased with a dollar in general investments whose values move with general price levels have low purchasing power risk and are more profitable during periods of rising prices example stocks of durable goods manufacturers those that provide fixed returns have a high purchasing power risk and are most profitable during periods of low inflation or declining price levels example deposit accounts and bonds o 4 Interest Rate Risk the chance that changes in interest rates will adversely affect a security s value those securities that offer purchasers a fixed period return will be especially affected by this interest rate changes result from changes in general relationship between the supply of and the demand for money prices of fixed income securities bonds and preferred stock typically drop when the interest rate rises most investment vehicles are subject to interest risk 2 although interest rate movements most directly affect fixed income securities they also affect other long term vehicles generally the higher the interest rate the lower the value of an investment vehicle and vice versa o 5 Liquidity Risk the risk of not being able to liquidate an investment conveniently and at a reasonable price one can generally sell an investment vehicle merely by significantly cutting its price however to be liquid an investment must be easily sold at a reasonable price example a security recently purchased for 1000 would not be viewed highly liquid if it could be quickly sold only at a greatly reduced price such as 500 the liquidity of a given investment is an important consideration in general investment vehicles traded in thin markets where demand and supply are small tend to be less liquid than those traded in broad markets stocks and bonds of major companies listed on the New York Stock Exchange are generally highly liquid others such as the stock of a small company in a declining industry are not o 6 Tax Risk the chance that Congress will make unfavorable changes in tax laws the greater the chance that such changes will drive down the after tax returns and market values of certain investments the greater the tax risk undesirable changes in tax laws include elimination of tax exemptions limitation of deductions and increases in tax rates virtually all investments are vulnerable to increase in tax rates but tax advantaged investments such as municipal and other bonds real estate and natural resources generally have greater tax risk o 7 Market Risk the risk that investment returns will decline because of market factors independent of the given investment examples political events economic events social events changes in investor tastes and preferences market risk actually embodies a number of different risks purchasing power risk interest rate risk and tax risk the impact of market factors on investment returns is not uniform 3 the degree and the direction of change in return differ among investment vehicles example o legislation placing restrictive import quotas on Japanese goods may result in an increase in the value and therefore in the return of domestic automobile and electronic stocks essentially market risk is reflected in the price volatility of a security the more volatile the price of a security the greater its perceived market risk o 8 Event Risk risk that comes from an unexpected even that has a significant and usually immediate effect on the underlying value of an investment event risk goes beyond business and financial risk it does not mean the company is doing poorly example July
View Full Document
Unlocking...