65: U11: Types of Investment Risk

Liquidity Risk

The risk that an asset cannot be sold on short notice without incurring a loss

5 primary unsystematic risks

-business -financial -liquidity -political -regulatory

A retired woman whose sole income comes from a portfolio of investments with a fixed rate of return is most affected by A) high inflation B) volatile interest rates C) bearish market conditions D) high income taxes

A Portfolios of fixed-income securities are most affected by inflation or rising prices. Rising prices or inflation is known as purchasing power risk. Because the portfolio has a fixed rate of return, interest rate changes will not affect the income received, but that income will have lost some of its purchasing power as a result of rising prices. Tax rates and market conditions would be of lesser importance to this investor. U11LO1

All are considered to be diversifiable EXCEPT -currency risk -liquidity risk -purchasing power risk -sovereign risk

C purchasing power risk is a systematic risk, therefore CANNOT be lessened through diversification

Legislative Risk

Changes in law that can affect an industry -Example: changes in the tax code

Systematic Risk

Risk in the return of an investment that is associated with the macroeconomic factors that affect all risky assets -war -inflation

Business Risk

Caused by poor management decisions

Sovereign Risk

Credit risk of a sovereign bond outside of the investor's home market

In 1986, a sweeping change was made to the U.S. tax code. This change had a severe effect upon those who had been investing in certain limited partnership tax shelters. This is an example of A) regulatory risk B) market risk C) business risk D) legislative risk

D What happened here was a legislative change severely limiting expenses that could be deducted from income. Changes wrought by government action are legislative in nature. U11LO2

When the 91-day Treasury bill rate is 3%, an investor decides to purchase a 20-year corporate bond at par with a coupon of 8%. If the corporate bond does not pay as expected, the investor's potential loss is considered A) purchasing power risk B) duration risk C) market cost D) opportunity cost

D When an investor forgoes the risk-free returns of the 91-day Treasury bill in favor of another investment, anything lost is considered the opportunity cost of passing up the sure thing. U11LO3

Political Risk

The likelihood that political forces will cause drastic changes in a country's business environment that will adversely affect the profit and other goals of a particular business enterprise.

Credit (default) risk

The possibility that a debtor will be unable to pay back principal/interest. -Credit risk, also known as default risk, is the risk that a company may have financial issues that lead to default on its debt obligations, bankruptcy, or both. -The lender (bank) takes on this risk because it is a possibility that the company cannot pay them back

Interest Rate Risk (systematic risk)

The risk that a security's future value will decline because of changes in interest rates. -Longer the maturity, the greater the price fluctuation when interest rates change

Regulatory Risk

The risk that changes in regulations may negatively affect the operations of a company.

Inflation Risk (Purchasing Power Risk) (systematic risk)

The risk that the return from an investment will not cover the loss in purchasing power caused by inflation.

Country Risk

Total risk of investing in the obligations of a certain country -Includes political and sovereign risk

market risk (systematic risk)

Uncertainty about an investment's future value because of potential changes in the market for that type of investment -Protect against market risk by having negatively correlated securities in your portfolio

Currency or exchange rate risk

Uncertainty that the value of either the foreign currency or the domestic currency will fluctuate

3 primary systematic risks

-market -interest rate -inflation or purchasing power

Your client purchases 100 shares of XYZ Electric Auto Company on the assumption that rising fuel costs will create more interest in this more efficient means of transportation. If he is wrong, the resulting drop in the market price of that stock would be due to A) business risk B) money-rate risk C) market risk D) purchasing power risk

A This question refers to a client who is investing in the success of a specific company. The failure of this company does not mean that all securities will be affected; therefore, he is not subjected to market risk. The failure of XYZ would be due to the fundamentals of the company itself and considered business risk. U11LO2

Which of the following is CORRECT regarding zero-coupon bonds? A) They eliminate reinvestment rate risk. B) They have low interest rate risk. C) They sell at a premium. D) They offer minimum price volatility.

A Zero-coupon bonds are sold at a deep discount from par value and have no coupon payments. Because there is nothing to reinvest, there is no reinvestment risk. That is why many investors prefer zero-coupon for specific goals, such as college education for children. The tradeoff is that no coupon also means higher interest rate risk. These bonds have maximum price volatility and respond sharply to interest rate changes.

A portfolio that is primarily invested in corporate bonds would be subject to I. credit risk II. interest rate risk III. opportunity cost IV. purchasing power risk

All Unless the security is a U.S. government bond, all bonds have credit risk. Including government bonds, they all fluctuate with changes in the interest rates and lose value due to inflation. Opportunity cost is the risk taken by choosing to invest in a lower-risk investment rather than attempt the higher returns that historically have been earned though investment in equities.

Liquidity risk would be greatest for an investor whose portfolio was primarily composed of A) ADRs listed on the NYSE B) municipal bond UITs C) municipal bonds D) Nasdaq stocks

C Any stock listed on the NYSE or traded on Nasdaq has high liquidity. Municipal bonds tend to be thinly traded, thereby exposing their holders to a higher degree of liquidity risk. UITs, regardless of their portfolio, stand ready to redeem their units so liquidity is not a problem for the investor. U11LO2

An investor has a majority of his portfolio in an ETF that mirrors the S&P 500. If the investor decided to liquidate that position and reinvest the proceeds into a single NYSE-listed common stock, it would most likely lead to an increase to the investor's A) purchasing power risk B) liquidity risk C) business risk D) interest rate risk

C Business risk is a nonsystematic (unsystematic) risk—one that diversification can mitigate. That is a benefit of owning an index like the S&P 500. However, when an investor is invested largely in a single security, if that company fails, so does the entire portfolio.

The risk to bondholders that bonds may lose value during periods of increasing inflation is known as A) reinvestment risk B) marketability risk C) credit risk D) interest rate risk

D Interest rate risk is the risk that as interest rates rise, bond prices fall. Periods of inflation are accompanied by rising interest rates. Another risk in this scenario, but not an answer choice, is purchasing power risk; each semiannual interest payment has less purchasing power due to inflation, and, of course, the purchasing power of the principal at maturity will be far less as well.

Which of the following describes unsystematic risk? A) It is related to market forces and cannot be diversified away. B) It is specific to an investment and cannot be diversified away. C) It is related to market forces and can be diversified away. D) It is specific to an investment and can be diversified away.

D It is critical to remember that unsystematic risk is diversifiable. That narrows the choices to 2. Then, we know that it is systematic risk that deals with the overall market, so that cuts it down to 1 possible choice.

Which of the following portfolios would most likely be exposed to the most inflation risk? A) 100% employer's company stock B) 34% diversified common stocks; 33% long-term convertible debentures; 33% non-cumulative preferred stock C) 50% U.S. Treasury bonds, average maturity 20 years; 30% U.S. Treasury notes, average maturity 5 years; 20% 90-day Treasury bills D) 75% S&P 500 index ETF; 25% municipal bond UIT

C Inflation risk is the bane of fixed income securities, especially those with longer maturities. On the other hand, as the percentage of common stock (or securities convertible into common stock) increases, the greater the inflation protection. Although placing all of one's portfolio into the employer's stock has enormous business risk, that doesn't answer this question. U11LO1

An agent for a well-known broker-dealer has taken it upon herself to look for investment opportunities for her clients. Her research indicates that, in spite of record earnings, the stock of GEMCO, Inc., is poised for a price reversal. Should this analysis prove correct, this would be an example of A) regulatory risk B) financial risk C) reinvestment risk D) market risk

D Market risk is the uncertainty that the market price of a stock will drop even when earnings are strong. Most stocks follow the "market" and this would appear to be no exception. Financial risk concerns itself with financing, particularly debt, so it is related to credit risk. Nothing in this question infers anything about financing difficulties. U11LO1

The business school of a local university is conducting a symposium on investment risk. An IAR attending the session dealing with systematic risk would expect to learn about A) business risk B) financial risk C) regulatory risk D) market risk

D Systematic (nondiversifiable) risks are those which tend to impact the securities market as a whole. It is generally thought of as market risk although there are other examples of systematic risk, such as inflation risk. The other choices are unsystematic risks because they can be mitigated through portfolio diversification U11LO1

From first to last, in what order would claimants receive payment in the event of bankruptcy? A) Secured debt, subordinated debentures, general creditors, preferred stockholders B) Preferred stockholders, secured debt, general creditors, subordinated debentures C) Subordinated debentures, preferred stockholders, general creditors, secured debt D) Secured debt, general creditors, subordinated debentures, preferred stockholders

D The liquidation order is as follows: secured debt holders, unsecured debt holders (including general creditors), holders of subordinated debt, preferred stockholders, and common stockholders. U11LO4

Which of the following securities are the most interest rate sensitive? I. Utility stocks II. Growth stocks III. Preferred stocks IV. Common stocks

I and III Utility and preferred stocks are the most interest rate sensitive. Utility stocks are interest rate sensitive because they are highly leveraged. Preferred stocks are interest rate sensitive because they have a set dividend and fluctuate in price like bonds when interest rates change.

Liquidation Priority

In the case of a corporation's liquidation, the order that is strictly followed for paying off creditors and stockholders: -secured creditors (mortgage bonds, collateral bonds) -unsecured creditors (debenture holders) -subordinated debt holders -preferred stockholders -common stockholders

Reinvestment risk (systematic risk)

Opposite of investment rate risk -Investor purchased a bond with a 10% coupon rate, later on securities were only paying 7%, investor would not be able to compound the investment at the original rate

Financial Risk

Relates primarily to those companies that use debt financing (leverage) -Inability to meet those debt obligations could lead to bankruptcy -The borrower of money takes on the risk