Question

Part I

Part one requires qualitative explanations that display your understanding of the concepts of risk and return. The article of Simon Hoyle gives some understanding of the concepts of risk and return. However, it was published in a newspaper where the target readers were not all educated in finance. You are required to answer the following questions while providing deeper insights about the concepts of risk and return than those that are provided in the article.

Read the article by Simon Hoyle and answer questions 1-4.

Baked beans a lot more predictable than shares BY SIMON HOYLE

11 March 2006

The Sydney Morning Herald

THE price of a tin of baked beans doesn't change much from day to day. The price of

a company’s shares, on the other hand, can change quite a lot. In investment terms, the price of the baked beans isn't as volatile as the share price.

While you might have a good idea of how much a tin of baked beans will cost you whenever you go 10 buy one, you can't be as certain about the price of a share. IBut there are ways you can make educated guesses about what the price of a share might do over a period of time. In other words, you can make educated guesses about the range of likely future outcomes, and hence about likely future volatility. A common way of measuring an asset's riskiness, or volatility, is the "standard deviation" of the asset's returns. Standard deviation is a statistical method of calculating the most likely range of returns from an asset. It is the method that analysts use to make long-term predictions from short-term data.

If you were to plot the returns from an asset on a graph, where the horizontal axis is the return the asset achieves every day, week or month, and the vertical axis is the number of times that return occurs, you'd get what's called a "distribution curve". This looks like a bell, and for that reason it's also sometimes known as a bell curve. What a bell curve tells you is that an asset's returns tend to be clustered around a certain number, and the further from that number you move along the horizontal axis, the fewer times the returns tend to crop up.

Calculating the standard deviation of an asset's returns tells you how far from the average return you have to move in order to include about two thirds of the range of an asset's returns. Moving two standard deviations from the average means you can cover about 95 per cent of the range of returns. In other words, you can say, with a high degree of certainty, what the range of an asset's returns will be.

"For example, an annualised volatility of 8 per cent together with an expected return of 20 per cent over the year can be used to produce an interval of possible return outcomes for the year," CommSec says.

"In this example there is an approximately two-thirds chance that the outcome after one year is 20 per cent, plus or minus 8 per cent (that is, 12 per cent to 28 per cent), and approximately a 95 per cent chance that the outcome will fall in an interval twice as wide (that is, 4 per cent to 36 per cent)."

A higher standard deviation means the likely outcomes range a long way from the average, and a lower standard deviation means the possible outcomes are more tightly concentrated around the average.

QUESTION (150 words)

Explain the distinction between Systematic and Unsystematic Risk? How can investors avoid each one of those risk?

Answer 1

Risk fo an investment in the financial market can be better understood when classified under two heads, namely Systematic risk and Unsystematic risk.

Systematic risk refers to the risk which is inherent in the market as a whole. Such risk can be caused due to any natural calamity,political events, interest rate fluctuations, and economic factors like GDP data.

Unsystematic risk refers to the risk which sector or a stock specific. un mishappening will only have an impact on the particular sector or the stock and not the whole market. Such variations can be caused by any business risk which includes earning or ratings downgrade, entrance of new competitor, product failure etc or Financial risk which involves chances of default.

The key differences are-

• systematic risk is uncontrollable whereas unsystematic risk is controllable.
• To mitigate the systematic risk techniques like hedging or asset allocation are used whereas for systematic risk portfolio diversification is used for management of risk.
• Systematic risk occurs due to macroeconomic factors, while unsystematic risk occurs due to the microeconomic factors

To avoid Systematic risk, investors can hedge their investments which is making an opposite position of the investment to protect oneselves from the falling market, or use asset allocation technique which involves investments in alternative investment tools which includes commodities,bonds etc

To avoid Unsystematic risk, investor can diversify his portfolio. This means that one should not invest all their money in one stock, but involve stocks of varied sectors in their portfolio.