Risk and Return PDF

# Risk and Return ## Risk - Variability of an asset's future returns - The chance that some unfavorable event will occur - Present whenever future outcomes are not completely certain or predictable. From the investor's viewpoint, the uncertainty of, or variability in, an asset's future return crea...

# Risk and Return ## Risk - Variability of an asset's future returns - The chance that some unfavorable event will occur - Present whenever future outcomes are not completely certain or predictable. From the investor's viewpoint, the uncertainty of, or variability in, an asset's future return creates risk - The greater the variability, the greater the risk ## Return - Also known as financial return, it is the money made or lost on an investment over some period of time - Can be expressed nominally as the change in the peso value of an investment over time - Can be expressed as a percentage derived from the ratio of profit to investment ## Risk-Return Relationship - Investment risk is generally categorized as the likelihood that the value of an asset will decrease, or in the case of returns for an investment option, that they will be negative. - The higher the potential for an asset to increase in value, the higher the level of investment risk (direct relationship). ## Two Main Categories of Risk ### Systematic Risk (Market Risk) - Uncontrollable by an organization - External factors that impact all (or many) companies in an industry or group ### Unsystematic Risk (Asset-Specific Risk) - Controllable by an organization - Asset-specific uncertainties that can affect the performance of an investment ## Types of Risks 1. Political/Regulatory Risk: Impact of political decisions and changes in regulations 2. Financial Risk: Capital structure of a company (degree of financial leverage/debt burden) 3. Interest Rate Risk: Impact of changing interest rates 4. Country Risk: Uncertainties that are specific to a country 5. Social Risk: Impact of changes in social norms, movements, and unrest 6. Environmental Risk: Uncertainty about environmental liabilities or the impact of changes in the environment 7. Operational Risk: Uncertainty about a company's operations 9. Management Risk: Impact that the decisions of a management team have on company ## Time vs. Risk - The farther away into the future a cash flow or an expected payoff is, the riskier (or more uncertain) it is. - There is a strong positive correlation between time and uncertainty. ## Risk Management Strategies 1. **Diversification** - Method of reducing unsystematic risk by investing in a number of different assets. - If one investment goes through a specific incident that causes it to underperform, the other investments will balance it out. 2. **Hedging** - Process of eliminating uncertainty by entering into an agreement with a counterparty. - Include forwards, options, futures, swaps, and other derivatives that provide a degree of certainty about what an investment can be bought or sold in the future. - Used by investors to reduce market risk, and by business managers to manage costs or lock-in revenues. 3. **Insurance** - Used to protect investors and operators from catastrophic events. 4. **Deleveraging** - Companies can lower the uncertainty of expected future financial performance by reducing the amount of debt they have. - Companies with lower leverage have more flexibility and a lower risk of bankruptcy or ceasing to operate. ## The Primary Market and Secondary Market ### Primary Market - A company that has been in existence for some time, looking to expand. - Company sells shares to investors for the first time. - Also known as: - Becoming listed or quoted - Floating on the stock market - Going public - Making an Initial Public Offering (IPO) ### Secondary Market - A company that has been already listed. - Investors will at some point wish to dispose of some or all of their shares and will generally do this through the stock exchange trading system. ## IPO: Initial Public Offering - The first time shares of a business are offered to the public. - A general offer made widely available by offering the shares to unconnected third parties. - The issuing company will have their shares traded on a stock market. - When a company's shares start trading on a stock exchange it is known as being listed. ### What benefits can the issuing company gain? ### Are there any potential dangers they must also consider? - **Raising Money by Selling Shares** - The raised money could be for companies own purpose and expansion, or it could be for some of their earlier investors. - Increasing public profile and awareness of the company. ## Return on Shares ### Dividends - Are the regular on-going income that a shareholder may receive. - The amount to be paid is determined by: - Profitability - Expectation - The amount to be paid is not fixed. - Expressed in % terms and in absolute terms (£/$). - Could be paid quarterly or half-yearly. ### Capital Gain - Equity investors hope their shares will increase in value to make a capital gain, as well as pay a regular income in the form of dividends. ## Dividends - Amount is not fixed. - Determined by the directors. - Driven by profitability and expectation. - Usually expressed in absolute terms e.g. 1p - Can be expressed as % of the share price (dividend yield) - Dividends not always paid to shareholders. ## Capital Gains - If shares are sold, then capital gains are realized. - If shares are not sold, then capital gains are unrealized. - Shares prices can go down as well as up. ## Shareholders Will Either Get: - Share of the gain OR share of the pain ## Shareholder Voting Rights - Right to attend company meetings. - Right to vote at meetings. ## Company Meetings - Generally occur once a year. - They give shareholders an opportunity to find out how the company is performing and to make decisions on what should happen. - Executives can be questioned by shareholders during meetings. - Shareholder decisions could be on a variety of matters including salary for the chief executive. ## Risks Involved in Owning Shares - **Low Profit** - Shareholders will be unlikely to sell shares and make any capital gain. - Bankruptcy: the shareholders will get nothing. - **No Dividends** - Share capped prices may fall - investors can lose capital even when dividends are paid. - **Price Risk** - Share capped prices may fall - investors can lose capital even when dividends are paid. - **Liquidity Risk** - Shares may be difficult to sell at a reasonable price or sold quickly enough to prevent a loss. - **Issuer Risk** - Issuing company may collapse - ordinary share may become worthless. - Shareholders are the last to be paid back in the event of a company winding up - lenders received their money first. - **Foreign Exchange Risk** - Currency price movements ## Types of Financial Markets - Sells securities (notes & bills) issued by US, for example. ### Bond Markets - Also called debit, credit or fixed income market. - A security in which an investor loans money for a defined period at a pre-established interest rate. - An agreement between the lender and borrower that contains the details of the loan and its payment. - Issued by corporations as well as municipalities, states and sovereign governments to finance projects and operation. ### Parties to a Bond 1. **Issuer** - Sell bonds or other debt instruments in the bond market to fund operations of their organizations. - Mostly made up of governments, banks and corporations. 2. **Investment Bank/Underwriter** - Made up of investment banks and other financial institutions that help issuer to sell bonds in the market. 3. **Purchaser/Investor** - Those who buy the debt that is being issued in the market. - Basically include every group mentioned as well as any other type of investor, including the individual. ### Maturity Date - Final date for the payment of any financial product when the principal along with the interest needs to be paid to the investor by the issuer.