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.