Investment risk

1. Understanding Investment Risk

  • Investment risk = risk that expected future benefits from investments do not materialize or are lower than required.

  • Firms manage investment risks to ensure optimal returns for clients.

  • Different asset classes (equities, bonds, currencies, commodities) have varying risk-return characteristics.

  • Diversification is used to minimize risk while maximizing return.

  • Investment managers track risk-adjusted returns using metrics like tracking error, information ratio, and Sharpe ratio.

2. Measurement of Investment Returns

2.1 Basic Concepts (LO 6.1.1)

  • Nominal return: The unadjusted return on an investment.

  • Real return: Adjusted for inflation using: (1+Nominal Rate)=(1+Real Rate)×(1+Inflation Rate)(1 + \text{Nominal Rate}) = (1 + \text{Real Rate}) \times (1 + \text{Inflation Rate})(1+Nominal Rate)=(1+Real Rate)×(1+Inflation Rate)

  • Total return = Income from investment + Capital gains/losses.

  • Holding Period Return (HPR): Total return over a specific holding period.

2.2 Compound Interest & Time Value of Money (LO 6.1.2)

  • Compound Interest: Earnings are reinvested, leading to exponential growth. S=X(1+r)nS = X (1 + r)^nS=X(1+r)n

  • Present Value (PV): Current equivalent of a future sum, discounted at a given rate. PV=S(1+r)nPV = \frac{S}{(1 + r)^n}PV=(1+r)nS​

  • Higher time horizon → Greater impact of compounding.

2.3 Variations in Rates of Return (LO 6.1.3)

  • Historical returns (1980-2011):

    • Equities ≈ 7.8%

    • Corporate bonds ≈ 6.1%

    • Treasury bills ≈ 1.6%

  • Higher returns → Higher risk (volatility).

  • Investment horizon matters:

    • Longer time → More equities.

    • Shorter time → Less volatile assets (bonds/cash).

 

3. Identification & Management of Investment Risks

3.1 Main Investment Risks (LO 6.2.1)

  1. Currency Risk: Value fluctuation in foreign exchange impacts investment.

    • Example: Chinese investor in US stocks faces market risk (stock price) & currency risk (USD/CNY rate).

  2. Interest Rate Risk:

    • Affects debt instruments (e.g., bond prices fall when interest rates rise).

    • Fixed vs. variable rates impact investment performance.

  3. Issuer Risk:

    • Risk of bond issuer defaulting.

    • Government bonds have sovereign risk, but still pose default risk.

  4. Equity Risk:

    • Capital growth risk: Share prices may fall.

    • Dividend risk: No guarantee of dividends.

    • Volatility risk: More price fluctuations = higher risk.

    • Strategic risk: Industry trends, management effectiveness, financial stability impact share performance.

  5. Commodity Risk:

    • Commodities (gold, oil, coffee) highly volatile.

    • Prices influenced by global supply/demand, geopolitical risks.

 

 

2.1.6 Property Risk

  • Unique Characteristics of Property

    • Highly segmented market due to unique features (location, design, etc.).

    • Subjective valuation due to lack of centralized trading and continuous pricing.

    • High upfront & transaction costs, legal complexities, and illiquidity.

    • Indivisibility makes diversification difficult.

    • Finite land supply—prices driven by demand shifts.

  • Risks in Property Investment

    • Property-Specific Risks: Location, tenant credit quality, lease length, property usage impact.

    • Market Risks: Interest rate impact, sector performance, rental income growth potential.

 

2.1.7 Liquidity Risk

  • Liquidity = ease of converting assets into cash or using them as collateral.

  • Investment Liquidity Risk: The inability to liquidate assets quickly & without losses.

    • Linked to market risk (selling below expected price due to urgency).

    • Linked to credit risk (higher collateral needed if investor’s credit is low).

 

2.2 Calculating Asset & Portfolio Investment Risk

  • Risk = volatility of investment value (measured by standard deviation).

    • Low SD → Stable returns, lower risk.

    • High SD → Fluctuating returns, higher risk.

  • Standard deviation helps predict return ranges (e.g., 9% avg return, 4% SD → ~67% chance of return between 5%-13%).

  • Comparison tools:

    • Benchmarking against market indices or peer funds.

    • Higher volatility = higher risk; investors prefer high returns with low volatility.

 

2.3 Alpha, Beta & Key Investor Ratios

  • Beta: Measures volatility vs. the market.

    • Beta = 1 → Moves with the market.

    • Beta > 1 → More volatile than the market.

    • Beta < 1 → Less volatile than the market.

  • Alpha: Measures outperformance vs. benchmark (adjusted for risk).

    • Negative alpha may result from high fees or poor management.

  • Sharpe Ratio: Risk-adjusted return (excess return per unit of risk).

  • Information Ratio: Measures excess return relative to benchmark & tracking error.

 

2.4 Illiquid Assets & Investment Risk

2.4.1 Venture Capital

  • Private equity investment in early-stage, high-growth firms.

  • Risks: High illiquidity, failure risk.

  • Benefits: Tax relief, potential high returns, low correlation with traditional markets.

2.4.2 Private Equity

  • Investment in non-publicly traded companies (capital injection or acquisition).

  • Private equity funds actively manage companies, aiming to increase value before selling (e.g., IPO).

Private Equity

  • Higher return potential, low correlation with standard investments.

  • High risk—possible loss of initial investment if the firm fails.

  • Lack of stock market listing reduces transparency.

Property as an Asset Class

  • Historically positive real long-term returns with low volatility.

  • Provides reliable income and diversification benefits.

  • Risks: prolonged downturns, low liquidity, and high transaction costs.

Responsible Investment (ESG)

  • ESG (Environmental, Social, Governance) factors influence investment decisions.

  • ESG investing has grown from a niche to a major market segment.

  • Example: JetBlue’s $550m sustainability-linked loan rewards lower carbon footprint.

  • ESG investments reached $35 trillion in 2021, projected to hit $50 trillion by 2025.

  • Increasing need for due diligence to prevent misleading ESG claims.

ESG Factors:

  • Environmental: Climate change, resource depletion.

  • Social: Human rights, labor welfare, diversity, consumer protection.

  • Governance: Corporate structure, executive pay, ethical management.

Correlation of Performance Between Asset Classes

  • Different asset classes react differently to market changes.

  • Asset allocation optimizes risk-reward by diversifying across asset classes.

  • Influenced by economic, political, and social factors.

Tracking Error

  • Measures how closely a portfolio follows its benchmark index.

  • Historical tracking error (ex post): Standard deviation of past returns.

  • Predictive tracking error (ex ante): Used by portfolio managers to control risk.

  • Index funds aim for minimal tracking error.

Investment Mandate & Risk Mitigation

  • Defines a fund’s objectives, strategies, sectors, and regions.

  • Includes investment limits, hedging, short-selling, and benchmark tracking.

  • Needs a balance between specificity (to guide investors) and flexibility (to adapt to market changes).

Investment Portfolio Risk Mitigation

1. Systematic & Non-Systematic Risk

  • Systematic risk: Market-wide and cannot be diversified away.

  • Non-systematic risk: Specific to assets; can be mitigated by diversification.

2. Optimisation & Diversification

  • Optimisation: Balancing expected returns with risk using mean-variance analysis.

  • Diversification: Investing in uncorrelated assets to reduce risk without lowering returns.

3. Portfolio Hedging

  • Uses derivatives (futures, options) to offset potential losses.

  • Example: Buying a put option to protect against stock price declines.

4. Short Selling

  • Selling borrowed stock in anticipation of price decline.

  • Risky: Potential for unlimited losses if the stock price rises.

  • Some regulators have banned short selling.

5. Risk Transfer

  • Using instruments like credit default swaps to manage credit exposure.

Monitoring, Managing & Reporting Investments

  1. Peer Review: Ensures adherence to firm-wide investment principles.

  2. Risk Review: Independent risk managers challenge investment decisions.

  3. Mandate Compliance: Systems check pre- and post-trade compliance.

  4. Performance Attribution: Assesses asset allocation, stock selection, and currency impact.

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