Page 64 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 4: Risk and Return Analysis

to maturity, with $4,040 of the total dollar return from the bond attributable to interest- Notes
on-interest. At a 12% reinvestment rate, the investor would realize an 11.14% compound
return, with almost 75% of the total return coming from interest-on-interest ($5,738/
$7,738). With no reinvestment of coupons (spending them as received), the investor would
achieve only a 5.57% return. In all cases, the bond is held to maturity.
Clearly, the reinvestment portion of the YTM concept is critical. In fact, for long-term
bonds the interest-on-interest component of the total realized yield may account for more
than three-fourths of the bond's total dollar return.
7. Bull-bear Market Risk: This risk arises from the variability in the market returns resulting
from alternating bull and bear market forces. When security index rises fairly consistently
from a low point, called a trough, over a period of time, this upward trend is called a bull
market. The bull market ends when the market index reaches a peak and starts a downward
trend. The period during which the market declines to the next trough is called a bear
market.

8. Management Risk: Management, all said and done, is made up of people who are mortal,
fallible and capable of making a mistake or a poor decision. Errors made by the management
can harm those who invested in their firms. Forecasting errors is difficult work and may
not be worth the effort and, as a result, imparts a needlessly sceptical outlook.

An agent-principal relationship exists when the shareholder owners delegate the
day-to-day decision-making authority to managers who are hired employees rather than
substantial owners. This theory suggests that owners will work harder to maximize the
value of the company than employees will. Various researches in the field indicate that
investors can reduce their losses to difficult-to-analyse management errors by buying
shares in those corporations in which the executives have significant equity investments.
9. Default Risk: It is that portion of an investment's total risk that results from changes in the
financial integrity of the investment.

Example: When a company that issues securities moves either further away from
bankruptcy or closer to it, these changes in the firm's financial integrity will be reflected in the
market price of its securities. The variability of return that investors experience, as a result of
changes in the credit worthiness of a firm in which they invested, is their default risk.
Almost all the losses suffered by investors as a result of default risk are not the result of
actual defaults and/or bankruptcies. Investor losses from default risk usually result from
security prices falling as the financial integrity of a corporation's weakness – market
prices of the troubled firm's securities will already have declined to near zero. However,
this is not always the case – 'creative' accounting practices in firms like Enron, WorldCom,
Arthur Anderson and Computer Associates may maintain quoted prices of stock even as
the company's net worth gets completely eroded. Thus, the bankruptcy losses would be
only a small part of the total losses resulting from the process of financial deterioration.
10. International Risk: International risk can include both country risk and exchange rate
risk.
(a) Exchange Rate Risk: All investors who invest internationally in today's increasingly
global investment arena face the prospect of uncertainty in the returns after they
convert the foreign gains back to their own currency. Unlike the past, when most US
investors ignored international investing alternatives, investors today must
recognize and understand exchange rate risk, which can be defined as the variability
in returns on securities caused by currency fluctuations. Exchange rate risk is
sometimes called currency risk.

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