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Unit 2: Risk and Return




          Non-systematic Risk: The variability in a security's total returns not related to overall market  Notes
          variability is called the non- systematic (non-market) risk. This risk is unique to a particular
          security and is associated with such factors as business and financial risk as well as liquidity risk.
          Although all securities tend to have some non-systematic risk, it is generally connected with
          common stocks.
          Remember the difference: Systematic (market) risk is attributable to broad macro factors affecting
          all securities. Non-systematic (non-market) risk is attributable to factors unique to a security.
          Different types systematic and unsystematic risk are explained as under:
          1.   Market Risk:  The variability  in a security's returns resulting from fluctuations in the
               aggregate market is  known as market risk. All securities  are exposed  to market  risk
               including recessions, wars, structural changes in the economy, tax law changes and even
               changes in consumer preferences. Market risk is sometimes  used synonymously with
               systematic risk.
          2.   Interest Rate Risk: The variability in  a security's return resulting from  changes in the
               level of interest rates  is referred  to as interest rate risk. Such  changes generally affect
               securities inversely; that is, other things being equal, security prices move inversely to
               interest rates. The reason for this movement is tied up with the valuation of securities.
               Interest rate risk affects bonds more directly than common stocks and is a major risk that
               all bondholders face. As interest rates change, bond prices change in the opposite direction.
          3.   Purchasing Power Risk: A factor affecting all securities is purchasing  power risk, also
               known  as inflation  risk. This  is the  possibility that the purchasing  power of invested
               dollars will decline. With uncertain inflation, the real (inflation-adjusted) return involves
               risk even if the nominal return is safe (e.g., a Treasury bond). This risk is related to interest
               rate risk, since interest rates generally rise as inflation increases, because lenders demand
               additional inflation premiums to compensate for the loss of purchasing power.
          4.   Regulation Risk:  Some investments  can be  relatively  attractive  to other investments
               because of certain regulations or tax laws that give them  an advantage  of some kind.
               Municipal bonds, for example, pay interest that is exempt from local, state and federal
               taxation. As a result of that special tax exemption, municipals can price bonds to yield a
               lower interest rate since the net after-tax yield may still make them attractive to investors.
               The risk of a regulatory change that could adversely affect the stature of an investment is
               a real danger. In 1987, tax law changes dramatically lessened the attractiveness of many
               existing limited partnerships that relied upon special tax considerations as part of their
               total return. Prices for many limited partnerships tumbled when investors were left with
               different securities, in effect, than what they originally bargained for. To make matters
               worse, there was no extensive secondary market for these illiquid securities and many
               investors found themselves unable to sell those securities at anything but 'firesale' prices
               if at all.
          5.   Business Risk: The risk of doing business in a particular industry or environment is called
               business risk. For example, as one of the largest steel producers, U.S. Steel faces unique
               problems.  Similarly,  General  Motors  faces  unique  problems  as  a  result  of  such
               developments as the global oil situation and Japanese imports.
          6.   Reinvestment Risk: The YTM calculation assumes that the investor reinvests all coupons
               received from a bond at a rate equal to the computed YTM on that bond, thereby earning
               interest on interest over the life of the bond at  the computed  YTM rate.  In effect,  this
               calculation assumes that the reinvestment rate is the yield to maturity.

               If the investor spends the coupons, or reinvests them at a rate different from the assumed
               reinvestment rate of 10%, the realized yield that will actually be earned at the termination




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