Business Finance Module 10: Investment Risks PDF 2021

# Business Finance Module 10: Investment Risks ## DepED Department of Education ## LU_Business Finance_Module 10 ## ABM - BUSINESS FINANCE ### Module 10: Investment Risks **Second Edition, 2021** * **Copyright © 2021** * **La Union Schools Division** * **Region I** All rights reserved. No par...

# Business Finance Module 10: Investment Risks ## DepED Department of Education ## LU_Business Finance_Module 10 ## ABM - BUSINESS FINANCE ### Module 10: Investment Risks **Second Edition, 2021** * **Copyright © 2021** * **La Union Schools Division** * **Region I** All rights reserved. No part of this module may be reproduced in any form without written permission from the copyright owners. ## Development Team of the Module * **Author:** Ronald June Balsomo * **Editor:** SDO La Union, Learning Resource Quality Assurance Team * **Content Reviewer:** Clarita C. Montemayor * **Language Reviewer:** Iren F. Abenes * **Illustrator:** Ernesto F. Ramos Jr. * **Design and Lay-out:** Angela Pauline C. Ganuelas ## Management Team * **Atty. Donato D. Balderas Jr.** * Schools Division Superintendent * **Vivian Luz S. Pagatpatan, Ph.D** * Assistant Schools Division Superintendent * **German E. Flora, Ph.D** * CID Chief * **Virgilio C. Boado, Ph.D** * EPS in Charge of LRMS * **Lorna O. Gaspar, EPS** * In Charge of ABM * **Michael Jason D. Morales** * PDO II * **Claire P. Toluyen** * Librarian II ## Printed in the Philippines by: **Department of Education – SDO La Union** * **Office Address:** Flores St., Catbangen, San Fernando City, La Union * **Union Telefax:** 072 - 205 - 0046 * **Email Address:** [email protected] ## Senior High School ## Business Finance ## Module 10: Investment Risks ## Introductory Message This Self-Learning Module (SLM) is prepared so that you, our dear learners, can continue your studies and learn while at home. Activities, questions, directions, exercises, and discussions are carefully stated for you to understand each lesson. Each SLM is composed of different parts. Each part shall guide you step-by-step as you discover and understand the lesson prepared for you. Pre-tests are provided to measure your prior knowledge on lessons in each SLM. This will tell you if you need to proceed on completing this module or if you need to ask your facilitator or your teacher's assistance for better understanding of the lesson. At the end of each module, you need to answer the post-test to self-check your learning. Answer keys are provided for each activity and test. We trust that you will be honest in using these. In addition to the material in the main text, Notes to the Teacher are also provided to our facilitators and parents for strategies and reminders on how they can best help you on your home-based learning. Please use this module with care. Do not put unnecessary marks on any part of this SLM. Use a separate sheet of paper in answering the exercises and tests. And read the instructions carefully before performing each task. If you have any questions in using this SLM or any difficulty in answering the tasks in this module, do not hesitate to consult your teacher or facilitator. Thank you. ## Target Risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment. Risk is an important component in assessment of the prospects of an investment. Most investors while making an investment consider less risk as favorable. The lesser the investment risk, more lucrative is the investment. However, the thumb rule is the higher the risk, the better the return. Quantifiably, risk is usually assessed by considering historical behaviors and outcomes. In finance, standard deviation is a common metric associated with risk. Standard deviation provides a measure of the volatility of asset prices in comparison to their historical averages in a given time frame. Overall, it is possible and prudent to manage investing risks by understanding the basics of risk and how it is measured. Learning the risks that can apply to different scenarios and some of the ways to manage them holistically will help all types of investors and business managers to avoid unnecessary and costly losses. In your previous lesson, you are done with the different types of investments. This module will provide you with information and activities that will help you understand the how to measure and the ways to minimize or reduce investment risks. After going through this module, you are expected to attain the following objectives: ### Learning Competency: * Measure and list ways to minimize or reduce investment risks in simple case problems (ABM_BF12-IVm-n-25). ### Subtasks: 1. Define investment risk. 2. Differentiate the different types of investment risk. 3. Compute systematic and non-systematic risk. 4. Analyze ways to minimize or reduce investment risk. 5. Evaluate low investment risk portfolio through simple case problems. ## Jumpstart ### Activity 1: KWL **Directions:** Fill in the KWL chart by writing what you know on the K column, what you want to know on the W column. Use a separate sheet of paper for your answers. | Content | Needs Improvement(1 point) | Adequate(2 points) | Quality(3 points) | Exemplary(5 points) | |---|---|---|---|---| | 5 points | Answers are partial or incomplete. Key points are not clear. Questions are not adequately answered. | Answers are not comprehensive or completely stated. Key points are addressed but not well supported. | Answers are accurate and complete. Key points are stated and supported. | Answers are comprehensive, accurate and complete. Key ideas are clearly stated, explained, and well supported. | ## Writing Conventions | 5 points (Spelling, punctuation, grammar, and complete sentences.) | Displays over five errors in spelling, punctuation, grammar, and sentence structure. | Displays three to five errors in spelling, punctuation, grammar, and sentence structure. | Displays one to three errors in spelling, punctuation, grammar, and sentence structure. | Displays no errors in spelling, punctuation, grammar, and sentence structure. | ## Discover ### Investment Risk is defined as the probability or uncertainty of losses rather than expected profit from investment due to a fall in the fair price of securities such as bonds, stocks, real estate, etc. Each type of investment is exposed to some degree of investment risk like the market risk i.e., the loss on the invested amount or the default risk i.e., the money invested is never returned back to the investor. ### Systematic and Non-systematic Risk | Risk | Definition | Also Known As | Examples | Measurement | |---|---|---|---|---| | **Systematic** | Uncertainty inherent to the entire market | Market risk, Undiversifiable risk | Changes in interest rates, recession, wars | Beta (β) | | **Non-systematic** | Uncertainty that comes with the company or industry | Specific risk, Diversifiable risk, residual risk | Rumors of a potential default, labor strikes, landslide in a mining company that disrupted the operation | Standard deviation (σ) less beta | ### Types of Investment Risks 1. **Market Risk** Market Risk is the risk of an investment losing its value due to various economic events that can affect the entire market. The Main Types of Market Risk include: * **a. Equity Risk:** This risk pertains to the investment in the shares. The market price of the shares is volatile and keeps on increasing or decreasing based on various factors. Thus, equity risk is the drop in the market price of the shares. * **b. Interest Rate Risk:** Interest rate risk applies to the debt securities. Interest rates affect the debt securities negatively i.e., the market value of the debt securities increases if the interest rates decrease. * **c. Currency Risk:** Currency risk pertains to foreign exchange investments. The risk of losing money on foreign exchange investments because of movement in the exchange rates is currency risk. For example, if the US dollar depreciates to Indian Rupee, the investment in US dollars will be of less value in Indian Rupee. 2. **Liquidity Risk** Liquidity risk is the risk of being not able to sell the securities at a fair price and converting into cash. Due to less liquidity in the market, the investor might have to sell the securities at a much lower price, thus, losing the value. 3. **Concentration Risk** Concentration Risk is the risk of loss on the invested amount because it was invested in only one security or one type of security. In concentration risk, the investor losses almost of the invested amount if the market value of the invested particular security goes down. 4. **Credit Risk** Credit risk applies to the risk of default on the bond issued by a Company or the government. The issuer of the bond may face financial difficulties due to which it may not be able to pay the interest or principal to the bond investors, thus, defaulting on its obligations. 5. **Re-investment Risk** The risk of loss from re-investing principal or income at a lower interest rate. Suppose you buy a bond paying 5%. Reinvestment risk will affect you if interest rates drop and you have to reinvest the regular interest payments at 4%. Reinvestment risk will also apply if the bond matures and you have to reinvest the principal at less than 5%. Reinvestment risk will not apply if you intend to spend the regular interest payments or the principal at maturity. 6. **Inflation Risk** The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation. Inflation erodes the purchasing power of money over time the same amount of money will buy fewer goods and services. Inflation risk is particularly relevant if you own cash or debt investments like bonds. Shares offer some protection against inflation because most companies can increase the prices they charge to their customers. Share prices should therefore rise in line with inflation. Real estate also offers some protection because landlords can increase rents over time. 7. **Horizon Risk** The risk that your investment horizon may be shortened because of an unforeseen event, for example, the loss of your job. This may force you to sell investments that you were expecting to hold for the long term. If you must sell at a time when the markets are down, you may lose money. Horizon Risk is the risk of shortening of investment horizon due to personal events like loss of job, marriage or buying a house, etc. 8. **Longevity Risk** Longevity Risk is the risk of outliving the savings or investments, particularly pertain to retired or nearing retirement individuals. 9. **Foreign Investment Risk** The risk of loss when investing in foreign countries. When you buy foreign investments, for example, the shares of companies in emerging markets, you face risks that do not exist in Canada, for example, the risk of nationalization. Foreign Investment Risk is the risk of investing in foreign countries. If the Country as a whole is at risk of falling GDP, high inflation, or civil unrest, the investment will lose money. ## Investment Risk Management Although there are risks in investment, these risks can be managed and controlled. Various ways of managing the risks include: 1. **Diversification:** Diversification includes spreading investment into various assets like stocks, bonds, and real estate, etc. This helps the investor as he will gain from other investments if one of them does not perform. Diversification can be achieved across different assets and also within the assets (e.g., investing across various sectors when investing in stocks). 2. **Investing Consistently (Averaging):** By investing consistently i.e., investing small amounts at regular intervals of time, the investor can average his investment. He will sometime buy high and sometimes buy low and maintain the initial cost price of the investment. However, if the investment rises in the market price, he will gain on the whole investment. 3. **Investing for the Long Term:** Long-term investments provide higher returns than short-term investments. Although there is short-term volatility in the prices of securities, however, they generally gain when invested over a longer horizon (5, 10, 20 years). ## Measuring Systematic and Non-systematic Risk | Measurement | Risk it Measures | Definition | Formula | |---|---|---|---| | Beta (β) | Systematic Risk | Measure of the systematic risk of an investment or portfolio VS. the market as a whole. The tendency of an investment to respond to swings in the market | $β_{p} = \frac{Cov(r_{p},r_{m})}{Var(r_{m})}$ | | Standard deviation (σ) | Total Risk | Sum of systematic and non-systematic risk. Total volatility of an investment | $σ = \sqrt{\frac{\sum_{i=1}^{n} (x_{i}- \overline{x})^{2}}{n-1}}$ where: $x_{i}$ - return $\overline{x}$ - average of returns n - no. of data points | ## Low Risks Investments Low Risk Investments are investments that are inherently safer than their counterparts. Stocks are low_risk compared to options, bonds are low risk compared to stocks and treasury bonds are low risk compared to corporate bonds. However, to define what low risk is, we need to know what risk is and how to quantify it. So let us first look at the ways to define risk, see how to quantify it, and then get into looking at some low-risk investments. There are numerous ways to define what risk is. To put it simply, Risk is something unwanted happening. In finance, it might be the moment of the price of an asset in the opposite direction to what the investor has bet. ### Low Risk Investments Low Risk Investment is an inherently safer investment than its counterparts. ## Diversification To minimize investment risk, an investor has to have a diversified portfolio. The composition of the portfolio depends on the risk appetite. A more conservative investor (i.e. investor who has less appetite for risk) may have a portfolio which is more skewed to fixed income instruments like time deposits. On the other hand, an investor who has a higher appetite for risk (i.e. an investor who is more willing to take risk) may have a portfolio which is more skewed to equity investments. Diversification is a risk management technique that combines a wide variety of investments within a portfolio to reduce risk. A well-diversified.portfolio can eliminate non-systematic risk. **Examples of how a more diversified portfolio can reduce the standard deviation of the portfolio:** | Two-Stock PHP 10,000 Portfolio (JFC and DMC) | Five-Stock PHP 10,000 Portfolio (JFC, GLO, URC, DMC, and PCOR) | |---|---| | **Year** | **Portfolio Value** | **Return** | **(xi-x)²** | **Year** | **Portfolio Value** | **Return** | **(x-x)²** | | 30/1/2014 | 10,000.00 | | | 30/1/2014 | 10,000.00 | | | | 28/2/2014 | 11,427.60 | 14.3% | 1.3% | 28/2/2014 | 10,921.56 | 9.2% | 0.4% | | 31/3/2014 | 11,477.74 | 0.4% | 0.1% | 31/3/2014 | 10,647.87 | -2.5% | 0.3% | | 30/4/2014 | 11,661.04 | 1.6% | 0.0% | 30/4/2014 | 10,859.22 | 2.0% | 0.0% | | 30/5/2014 | 11,848.70 | 1.6% | 0.0% | 30/5/2014 | 10,981.69 | 1.1% | 0.0% | | 30/6/2014 | 11,976.59 | 1.1% | 0.0% | 30/6/2014 | 11,122.52 | 1.3% | 0.0% | | 31/7/2014 | 11,923.45 | -0.4% | 0.1% | 31/7/2014 | 11,337.00 | 1.9% | 0.0% | | 29/8/2014 | 12,609.95 | 5.8% | 0.1% | 29/8/2014 | 11,593.20 | 2.3% | 0.0% | | 30/9/2014 | 13,048.32 | 3.5% | 0.0% | 30/9/2014 | 12,009.73 | 3.6% | 0.0% | | 31/10/2014 | 13,219.55 | 1.3% | 0.0% | 31/10/2014 | 12,139.22 | 1.1% | 0.0% | | 28/11/2014 | 13,623.45 | 3.1% | 0.0% | 28/11/2014 | 12,428.98 | 2.4% | 0.0% | | 29/12/2014 | 13,635.51 | 0.1% | 0.1% | 29/12/2014 | 12,356.12 | -0.6% | 0.1% | | | | | 1.7% | | | | 0.9% | | σ | 4.2% | | | σ | 3.1% | | | | **Year** | **Value** | **Return** | **(xi-X)2** | |---|---|---|---| | 30/1/2014 | 10,000.00 | | | | 28/2/2014 | 10,635.31 | 6.4% | 0.2% | | 31/3/2014 | 10,641.46 | 0.1% | 0.0% | | 30/4/2014 | 11,103.62 | 4.3% | 0.1% | | 30/5/2014 | 11,003.88 | -0.9% | 0.1% | | 30/6/2014 | 11,329.41 | 3.0% | 0.0% | | 31/7/2014 | 11,363.36 | 0.3% | 0.0% | | 29/8/2014 | 11,671.36 | 2.7% | 0.0% | | 30/9/2014 | 12,055.69 | 3.3% | 0.0% | | 31/10/2014 | 11,944.22 | -0.9% | 0.1% | | 28/11/2014 | 12,074.41 | 1.1% | 0.0% | | 29/12/2014 | 11,968.78 | -0.9% | 0.1% | | | | | 0.6% | | σ | 2.4% | | | ## Explore ### Activity 2: KWL **Directions:** Continuing the Activity 1, fill in the last column L the lesson that you have learned. Use a separate sheet of paper for your answers. | Content | Needs Improvement(1 point) | Adequate(2 points) | Quality(3 points) | Exemplary(5 points) | |---|---|---|---|---| | 5 pts | Answers are partial or incomplete. Key points are not clear. Question not adequately answered. | Answers are not comprehensive or completely stated. Key points are addressed, but not well supported. | Answers are accurate and complete. Key points are stated and supported. | Answers are comprehensive, accurate and complete. Key ideas are clearly stated, explained, and well supported. | ## Writing Conventions | 5 pts (Spelling, punctuation, grammar, and complete sentences.) | Displays over five errors in spelling, punctuation, grammar, and sentence structure. | Displays three to five errors in spelling, punctuation, grammar, and sentence structure. | Displays one to three errors in spelling, punctuation, grammar, and sentence structure. | Displays no errors in spelling, punctuation, grammar, and sentence structure. | ## Activity 3: WORD HUNT! **Directions:** Find ten (10) words that are related to investment risk. Use a separate sheet of paper for your answers. ``` L O N G T E R M S L O W R I S K A C F T Y D G C J R R D O N E D R F K F X E C Y E W E U L I Q U I D I T Y R N U R D I D I T T F I R S T I M I S L T E D Ο M E V E A Y N F C E D E A T S C G H U A G D I R Y T H G D N H Ο R I Z Ο N F Ο Ο N R T F Q F H L ``` ## Gauge **Directions:** Read and understand each statement carefully. Use a separate sheet of paper for your answers. 1. It is defined as the probability or uncertainty of losses rather than profit from Investment due to a fall in the fair price of securities such as bonds, stocks, real estate, etc. * A. Accounting Risk * **B. Investment Risk** * C. Profit Risk * D. Saving Risk 2. It is the risk of being not able to sell the securities at a fair price and converting into cash. * A. Credit Risk * **B. Liquidity Risk** * C. Market Risk * D. Re-investment Risk 3. The risk of an investment losing its value due to various economic events that can affect the entire market. * A. Credit Risk * **B. Liquidity Risk** * C. Market Risk * D. Re-investment Risk 4. Applies to the risk of default on the bond issued by a Company or the government. * **A. Credit Risk** * B. Liquidity Risk * C. Market Risk * D. Re-investment Risk 5. The risk of a loss in your purchasing power because the value of your investments does not keep up with inflation. * A. Horizon Risk * **B. Inflation Risk** * C. Longevity Risk * D. Foreign Investment Risk 6. The risk that your investment horizon may be shortened because of an unforeseen event, for example, the loss of your job. * **B. Horizon Risk** * D. Longevity Risk * B. Inflation Risk * D. Foreign Investment Risk 7. The risk of outliving the savings or investments, particularly pertain to retired or nearing retirement individuals. * A. Horizon Risk * **C. Longevity Risk** * B. Inflation Risk * D. Foreign Investment Risk 8. The risk of loss when investing in foreign countries. * A. Horizon Risk * B. Inflation Risk * **C. Foreign Investment Risk** * D. Foreign Investment Risk 9. This helps the investor as he will gain from other investments if one of them does not perform. * **A. Diversification** * B. Investing Consistently * C. Investing for the long term * D. Verification of Investment 10. By investing consistently i.e., investing small amounts at regular intervals of time, the investor can average his investment. * A. Diversification * **B. Investing Consistently** * C. Investing for the long term * D. Verification of Investment ## 17 LU_Business Finance_Module