Tutorial 2 - Risk and Return - Question

KOLEJ UNIVERSITI TUNKU ABDUL RAHMAN
FACULTY OF ACCOUNTANCY, FINANCE AND BUSINESS

ACADEMIC YEAR 2016/2017
BBMF2023 PRINCIPLE OF INVESTMENT
Tutorial 2: Risk and Returns
1. Explain the importance of return.
-Return indicates how rapidly an investor can build wealth.

-If return is higher, the lesser the time needed to build required wealth.
-Allow the investor to measure their investment performance
-If it has higher return means the investment is doing well.
2. Explain why internal characteristics and external forces are the key factor in return.
Return is greatly influenced by the Internal Characteristics of an investment, such as:

i) Type or risk of investment
-There are many type of risk of investment such as business risk, financial risk, interest rate
risk and tax risk. For example, lower tax rates reduce the tax benefit of municipal bond
interest.
ii) Issuer’s management
- Issuer’s management can be one of the key elements in the internal characteristics as a
good management will generally produce a good return due to efficient management of
internal resources.
iii) Issuer’s financing
-The issuer’s financing also lead to the variation in return depending on the stability of the
issuer’s financial.
-A strong financial of firm generally generate higher return than those who are weak.
-Investment with higher return generally consist of higher risk, as the uncertainty have to be
compensated by higher return.
External Forces are the forces other than the internal characteristics that affect the return of
an investment. The forces can be:
i)Political environment
Political stability creates investor and business confidence because there is more visibility
into possible investment returns.
ii) Business environment
iii) Economic environment
Firms invest to meet future demand. If demand is falling, then firms will cut back on
investment. If economic prospects improve, then firms will rise on investment.
-Financial crisis is one of the economic environments which greatly affect the stock
investment performance.
3. Distinguish between market risk and business risk. How is interest rate risk related to
inflation risk?
Market risk
-Is the variability in return due to fluctuations in the overall market.
-It included a wide range of factors exogenous (derived externally) to securities themselves.
Business risk
-is the risk of doing business in a particular industry or environment.
-Interest rate risk and inflation risk are clearly directly related.
-Interest rates and inflation generally rise and fall together.
4. Briefly explain the required rate of return, real rate of return, expected inflation premium,
and risk premium.
Required Rate of Return

-The rate of return an investor must earn on an investment to be fully compensated for its
risk.
Real rate of return

-Equals the nominal rate of return minus the inflation rate.
Expected Inflation Premium

-The average rate of inflation expected in the futures.
Risk Premium
-Additional return an investor requires on risky investment to compensate for risks based
upon issue and issuer characteristics
-Issue characteristics are type, maturity and features.
-Issuer characteristics are the industry and company factors
-Equity risk premium is the difference between stock and risk-free returns.
5. Explain why holding period return is usually measure the return for one year or less.
-Holding period return does not consider time value of money in the formula.
-Thus, it is only suitable in measuring the return within one-year time.
-It will become less practical or inaccurate if it is used in measuring return for more than
one year.
6. Explain TWO (2) type of return that investor can get from an investment.
-Income: cash or near-cash that is received as a result of owning an investment.
-Capital gains (or losses): the difference between the proceeds from the sale of an
investment and its original purchase price.
7. Discuss a risk that associated with the following investment

a) Real estate
b) Stocks
c) Bonds
d) Certificates of deposit
8. Discuss the exchange rate risk and how does it affect your investment position.
-Exchange rate risk refers to the risk caused by the varying exchange rates between the
currencies of two countries.
-When an investment involve the exchange of currency between two countries, then
exchange rate risk exist.
-Usually, it will affect the investment position of a cross broader investment, such as the
purchase of foreign shares which denominated in foreign currency. The appreciation of a
local currency will decrease the investment return from a foreign investment.
9. Standard deviation can be used as one of the measures of risk. Explain the idea behind the
use of standard deviation.
-Standard deviation is a statistic used to measure the dispersion (variation) of returns
around an asset’s average or expected return.
-An asset which is classified as risky tend to have higher dispersion because it indicates that
the actual return might have higher difference with expected return.
-Thus, the logic behind the use of standard deviation is that standard deviation specifically
captures the variation of return with the expected return.
-The higher the value of standard deviation, the greater the variation or dispersion, hence
lead to greater risk.
10. Explain the following terms with example:

a) Risk-indifferent
-Risk-indifferent describes an investor who does not require a change in return as
compensation for greater risk.
-Thus, they will only concern on the expected return irrespective of the risk.
-If an investor face with a choice between receiving RM100 with 100% certainty, or 50%
chance of getting RM200.
-Risk- indifferent investor has no preference on it because the expected return for both
options are the same.
b) Risk-averse
-Risk-averse describes an investor who requires greater return in exchange for greater risk.
Thus, they will only concern the risk irrespective of the return.
-If an investor face with a choice between receiving RM100 with 100% certainty, or 50%
chance of getting RM200.
Risk-averse investor will choose the “for sure thing” of RM100 with 100% certainty as it is
the lowest risk
c) Risk-seeking
-Risk-seeking describes an investor who will accept a lower return in exchange for greater
risk.
-Thus, they will only concern the return irrespective of the risk
-In the similar situation, risk-seeking investor will opt for RM200 with 50% certainty as it
has the chance to get higher return although the chance of getting higher return is lower.

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KOLEJ UNIVERSITI TUNKU ABDUL RAHMAN

FACULTY OF ACCOUNTANCY, FINANCE AND BUSINESS

BBMF2023 PRINCIPLE OF INVESTMENT

Tutorial 2: Risk and Returns

1. Explain the importance of return.

-Return indicates how rapidly an investor can build wealth.

Return is greatly influenced by the Internal Characteristics of an investment, such as:

Required Rate of Return

Real rate of return

Expected Inflation Premium

7. Discuss a risk that associated with the following investment

10. Explain the following terms with example:

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