INVESTMENT RISKS
A company that is extensively overleveraged using debt financing whenever available would be exposing its investors to A) financial risk B) call risk C) liquidity risk D) business risk
A) financial risk Debt financing or utilizing debt leverage too much can lead to the inability to meet principal and interest payments on a company's debt obligations. This is the definition of financial risk. Reference: 2.2.2 in the License Exam Manual
An investor who relies heavily on fixed interest payments from long-term (25-30 years) bonds should be most concerned with A) inflation risk B) reinvestment risk C) financial risk D) legislative risk
A) inflation risk Sometimes referred to as purchasing power risk, inflation risk is the effect of rising prices over a long period while an investor is collecting fixed interest payments. For example, if a bond's yield is lower than the inflation rate, the purchasing power of the interest payments received diminishes over time. Reference: 2.2.1 in the License Exam Manual
All investors and investments are different. Recognizing this, it is TRUE that A) no investment should be deemed suitable for every investor B) most investments are not deemed suitable for any investor C) all investments can be deemed suitable for every investor D) some investments can be suitable for all investors
A) no investment should be deemed suitable for every investor Because all investments are different, carrying different levels of risk and reward, no investment can ever be assumed as being suitable for all investors. Each investment type and/or strategy will be suitable for some investors but not all. Reference: 2.2 in the License Exam Manual
All of the following are nonsystematic risks EXCEPT A) purchasing power risk B) capital risk C) business risk D) call risk
A) purchasing power risk Purchasing power or inflation risk is a systematic risk. Capital risk, business risk, and call risk, among others, are nonsystematic risks, those that portfolio diversification can help to reduce. Reference: 2.2.2 in the License Exam Manual
An investor holds shares of a manufacturing company where disposal of the by-products produced during the manufacturing process is necessary. The Environmental Protection Agency (EPA) updates the rules applicable to disposing of the product. For the investor, these changes present a form of A) regulatory risk B) political risk C) financial risk D) liquidity risk
A) regulatory risk Changes in the regulatory climate or specific rules that might impact how a company operates or its ability to do so profitably are recognized as regulatory risk.
There are several types of investment risks that will generally fall into 2 categories. These categories are known as A) systematic and nonsystematic B) high return and low return C) investment and investor D) averse and nonaverse
A) systematic and nonsystematic The 2 categories of investment risks are systematic (the risk that change in overall economy will impact individual securities) and nonsystematic (those risks that are unique to a particular industry, business, or investment type). Reference: 2.2 in the License Exam Manual
Regarding different types of risk, which of the following is TRUE? A) Enactment of, or changes in, laws represent political risk. B) Enactment of, or changes in laws, represent potential legislative risk. C) Changes in regulations represent political risk. D) Changes in regulations represent potential legislative risk.
B) Enactment of, or changes in laws, represent potential legislative risk. The enactment of, or changes in, laws represent potential legislative risk, whereas enactment of, or changes in, regulations represent regulatory risk. Political risk is specific to potential political instability associated more with emerging economies. Reference: 2.2.2 in the License Exam Manual
Which of the following accurately characterizes capital risk? A) It is the potential for loss due to an issuer's financial strength. B) It can be reduced by diversification. C) It is minimal when investing in derivatives, such as options. D) It is always high when investing in government securities.
B) It can be reduced by diversification. Capital risk is one of the nonsystematic risks that can be reduced by diversification. It represents the potential for loss due to circumstances unrelated to an issuer's financial strength. While it is considered minimal to none for U.S. government securities, it is generally high for derivative products, such as options.
By virtue of a stocks listing for trading on a U.S. stock exchange, which of the following risks is reduced or even recognized as eliminated? A) Equity risk B) Liquidity risk C) Price risk D) Market risk
B) Liquidity risk One of the advantages of a security being traded on a U.S. listed stock exchange is the ready availability of buyers and sellers. This means the investment can be considered a liquid one—easy to divest of at a fair price, if and when one needs to.
Which of the following statements best describes financial risk? A) A risk generally caused by poor management and operating decisions B) The risk that an issuer will be unable to meet interest and principal payments on debt obligations C) The risk that a security with a call feature might be called before maturity D) The risk that when interest rates decline, it is difficult to invest proceeds from redemptions
B) The risk that an issuer will be unable to meet interest and principal payments on debt obligations Financial risk emanates from the use debt financing (leverage). It represents the potential inability to meet interest and principal payments on debt obligations, which can lead to bankruptcy. It is sometimes called credit risk or default risk.
A company is about to introduce a new product. While confident in the product's appeal and market, it is still an unknown factor until sales results are viewed later. Investors holding stock in the company are at this time specifically exposed to A) financial risk B) business risk C) call risk D) reinvestment risk
B) business risk Business risk is an operating risk related to poor or untimely management decisions. Decisions regarding if and when to introduce new products are one example of those that might expose investors specifically to business risk.
An investor holding a 4.5% callable bond has it called away by the issuer when interest rates fall to 3.5%. This is an example of A) business risk, which can lead to financial risk B) call risk, which can lead to reinvestment risk C) interest-rate risk, which can lead to financial risk D) market risk, which can lead to interest-rate risk
B) call risk, which can lead to reinvestment risk Call risk (the risk that when interest rates fall, issuers will call in existing callable debt) issues often leads to reinvestment risk for the investor. While receiving one's principal back sooner than expected, the investor is now left to reinvest at the now lower yield rates.
Interest-rate risk A) occurs when interest rates fall, pushing bond prices lower B) cannot be reduced by diversification C) is often called purchasing power risk D) occurs when interest rates rise, pushing bond prices higher
B) cannot be reduced by diversification Interest-rate risk is one of the systematic risks that cannot be reduced by diversification. It is the risk that fluctuating interest rates will impact bond prices. Primarily, when interest rates are rising, bond prices will be pushed lower.
An investor in the United States is purchasing a security traded on a foreign securities exchange. The transaction on the exchange is priced in euros. The circumstances of this purchase and subsequent sale of the security exposes the investor to A) liquidity risk B) currency risk C) business risk D) financial risk
B) currency risk Whenever investing abroad, investors may be exposed to a number of risks that would not occur when investing in the U.S. domestic markets. Currency risk, for example, is the possibility that an investment denominated in one currency could decline if the value of that currency declines in its exchange rate with the U.S. dollar. Reference: 2.2.2 in the License Exam Manual
Political risk is more associated with A) developed economies and not with emerging economies B) emerging economies, but could occur even in highly developed ones C) emerging economies and can never occur in highly developed ones D) developed economies but could occur even in emerging economies
B) emerging economies, but could occur even in highly developed ones While political risk, the potential instability in the political climate of a country or market, is mostly associated with emerging economies, it must be recognized that it can occur even in highly developed ones as well.
The effect of continually rising retail prices on the investment returns of one's portfolio is best described as A) reinvestment risk B) inflation risk C) business risk D) call risk
B) inflation risk Inflation, or continually rising prices, reduces the purchasing power that one's investment returns will have. This is the essence of inflation risk. Reference: 2.2.1 in the License Exam Manual
A luxury tax that consumers must pay that is levied on nonessential items of a certain value or more is an example of A) political risk B) legislative risk C) regulatory risk D) consumer risk
B) legislative risk Legislative risk is the risk that laws are introduced or amended. Always associate changes in tax laws or code with legislative risk.
A change to tax rates on dividends would be an example of A) currency risk B) legislative risk C) liquidity risk D) purchasing power risk
B) legislative risk When legislation is passed that affects the income received on an investment, the investor is exposed to legislative risk. Only a legislature can change tax rates. Reference: 2.2.2 in the License Exam Manual
The risk that an investor might not be able to sell an investment quickly and at a fair market price is known as A) inflation or purchasing power risk B) liquidity or marketability risk C) financial or default risk D) call or reinvestment risk
B) liquidity or marketability risk Having investments that are liquid means being able to divest of them quickly at a fair price. Liquidity risk comes for investors holding assets where doing that might not be possible.
The Federal Reserve Bank is raising interest rates, this will A) have no impact on bond prices in the open market B) push bond prices lower in the open market C) push bond prices higher in the open market D) make bonds trading in the open market more desirable
B) push bond prices lower in the open market This is interest-rate risk. When interest rates are rising, bond prices in the open market are pushed down. Rate movements and prices have an inverse relationship. Those already holding the bonds in their portfolios see their investments decrease in value. This also makes bonds trading in the open market less desirable because new issue bonds will be yielding the now higher rates and comparably be more desirable. Reference: 2.2.1 in the License Exam Manual
The risk that changes in the overall economy will have an adverse effect on individual securities regardless of the company's circumstances is known as A) investment risk B) systematic risk C) nonsystematic risk D) securities risk
B) systematic risk Systematic risk is the risk that changes in the overall economy will have an adverse effect on individual securities regardless of the company's circumstances. Common causes that can impact all securities or investments might be war, global security threats, and inflation.
Which of the following statements regarding systematic risk as it relates to an investment portfolio is TRUE? A) Diversification can be used to eliminate it completely. B) Diversification ensures that portfolios are not subject to it. C) Diversification will not eliminate it. D) Diversification cannot mitigate it to any extent.
C) Diversification will not eliminate it. Systematic risk is the risk that changes in the overall economy will have an adverse effect on individual securities, regardless of the company's circumstances. Understanding what it is, is to know that no amount of diversification will eliminate it completely. While one might be able to mitigate it somewhat, one cannot diversify away systematic risk.
Which of the following are considered systematic risks—those that would impact all businesses?Market riskInflation riskRegulatory riskBusiness risk A) II and III B) I and IV C) I and II D) III and IV
C) I and II Systematic risk is the risk that changes in the overall economy will impact securities regardless of the company's business. Examples of that are inflation (purchasing power) risk, interest-rate risk, and market risk. Business risk and regulatory risk are examples of nonsystematic risk, the kind of risk that might be unique to certain businesses or industries. Reference: 2.2.1 in the License Exam Manual
An investor chooses to have a portfolio made up of domestically listed U.S. securities only. In so doing, this investor is primarily avoiding which of the following 2 risks? A) Call and reinvestment B) Market and purchasing power C) Political and currency D) Inflation and interest rate
C) Political and currency By having a portfolio made up of only domestically listed U.S. securities, the investor is primarily avoiding political risk and currency risk. Political risk is attributable to political instability, rarely associated with U.S. domestic markets. Currency risk is most prevalent when buying or selling involves a foreign currency that can fluctuate in value against the U.S. dollar. While these 2 are avoided, the investor could still be exposed to each of the other risks listed here. Reference: 2.2.2 in the License Exam Manual
Regarding investment risks, which of the following is TRUE? A) Lower yields should be expected when assuming more risk. B) Safer investments come with higher yields. C) Safer investments tend to offer lower yields. D) Higher yields should be expected when assuming less risk.
C) Safer investments tend to offer lower yields. Safe investments tend to offer lower yields, but investments where considerable risk is attached should offer much higher potential yields. Higher yield is the potential reward for assuming greater risk.
All of the following are examples of legislative risk EXCEPT A) a law that would either allow or eliminate a tax deduction B) a luxury tax imposed on high-priced amenities such as automobiles or yachts C) an environmental regulation enacted to require certain precautions be taken D) changes made to the tax code regarding income tax
C) an environmental regulation enacted to require certain precautions be taken Legislative risk results from a change in the law. Changes to the tax code are the most common legislative risks. Regulatory risk comes from a change to regulations that might impact certain individuals or businesses. The imposition of environmental regulations is one such example. Reference: 2.2.2 in the License Exam Manual
Some bonds have a feature that prohibits them from being called by the issuer before a certain date. This is known as A) interest-rate exposure B) capital risk C) call protection D) financial risk
C) call protection Some callable bonds have a feature known as call protection, which essentially limits the issuer from calling them in before a certain date. The length of the call is predetermined, and during this time, the investor knows that the bind cannot be called away.
For investors, changes made to the tax code by the IRS are known as a form of A) regulatory risk B) financial risk C) legislative risk D) political risk
C) legislative risk Legislative risk results from changes in the law, not regulations. Changes in tax laws are one example. Reference: 2.2.2 in the License Exam Manual
An investor owns a bond purchased several years ago yielding 3%, which at the time was considered a fair return. However, these fixed 3% interest payments have not kept up with the inflation rate. This situation presents the investor with A) currency risk B) financial risk C) purchasing power risk D) liquidity risk
C) purchasing power risk Inflation can generally be associated with diminished purchasing power—purchasing power risk. During times of inflation, a dollar will not be able to purchase what it had previously in the way of goods and services. Investments such as bonds paying fixed rates of return are negatively impacted during these times. Reference: 2.2.1 in the License Exam Manual
Inflation risk is most closely associated with A) interest-rate risk B) call risk C) purchasing power risk D) nonsystematic risk
C) purchasing power risk When prices are rising (inflation), purchasing power is reduced. During inflationary periods, a dollar today often doesn't purchase the quantity of goods and services it purchased yesterday.
Those holding the securities of a company where rules might change that impact or upset the way the company does business are exposed to A) currency risk B) liquidity risk C) regulatory risk D) financial risk
C) regulatory risk Changes in the overall regulatory climate or specific rule changes that impact an individual company's business model can have an effect on the company's performance or ability to operate profitably. Those holding the securities of such companies are exposed to regulatory risk. Reference: 2.2.2 in the License Exam Manual
Call risk is most closely associated with A) financial risk B) market risk C) reinvestment risk D) currency risk
C) reinvestment risk Call risk is the risk that a bond might be called before maturity. Often when this occurs, investors who receive their principal back sooner than anticipated are left to find ways to reinvest that will achieve the same returns—reinvestment risk.
The ratings on the debt instruments of a foreign country with outstanding loans from a number of other countries worldwide have been downgraded. The impact felt due to the risk of possible default is known as A) interest-rate risk B) political risk C) sovereign risk D) legislative risk
C) sovereign risk While it can be noted that sovereign risk is a type of political risk, the risk of default by a country on its debt instruments is specifically recognized as sovereign risk. Reference: 2.2.2 in the License Exam Manual
Portfolio diversifying might be used to reduce which of the following risks? A) Interest-rate risk B) Inflation risk C) Market risk D) Business risk
D) Business risk Nonsystematic risks can be reduced using diversification. These would include business, financial, credit, and liquidity risk (among others). Market, inflation, and interest-rate risks are types of systematic risks that are considered nondiversifiable because they impact all investments and, therefore, cannot be "diversified" away or mitigated simply by diversifying. Reference: 2.2.2 in the License Exam Manual
When interest rates are falling, which bonds are most likely to expose holders to call risk? A) All bonds, regardless of the coupon rate B) All bonds, regardless of whether or not they are callable C) Callable bonds with lower coupons D) Callable bonds with higher coupons
D) Callable bonds with higher coupons When interest rates fall, issuers will call in their callable debt issues with the highest coupon rates first. These are the ones currently costing the issuer the most in interest payments. Therefore, when interest rates are falling, holders of higher coupon bonds are more exposed to call risk than are those investors holding lower coupon bonds. Reference: 2.2.2 in the License Exam Manual
Investors face many different risks. Which of the following would be factors of systematic risk?WarGlobal security threatsCall riskProduct development pipeline A) II and IV B) III and IV C) II and III D) I and II
D) I and II Systematic risk points to changes in the overall economy. It has an adverse effect on individual securities apart from the company's circumstances. It is generally caused by factors that affect all businesses, such as war, global security threats, or rampant inflation. No matter how diversified a portfolio is, it remains subject to systematic risk. An investor cannot diversify systematic risk away.
Which of the following is TRUE regarding currency risk? A) It is a systematic risk and, therefore, cannot be reduced by diversification. B) It is a systematic risk and, therefore, can be reduced by diversification. C) It is a nonsystematic risk and, therefore, cannot be reduced by diversification. D) It is a nonsystematic risk and, therefore, can be reduced by diversification
D) It is a nonsystematic risk and, therefore, can be reduced by diversification. Currency risk is the possibility that an investment denominated in one currency could decline if the value of that currency declines in its exchange rate with the U.S. dollar. This is one of the severable nonsystematic risks that can be mitigated by utilizing diversification. Reference: 2.2.2 in the License Exam Manual
The ability to take the proceeds from the redemption of one security or investment and allocate those proceeds in such a way so as to maintain the same level of return is expressed in which of the following concepts? A) Interest-rate risk B) Purchasing power risk C) Market risk D) Reinvestment risk
D) Reinvestment risk The concept of reinvestment risk has to do with the ability to reinvest proceeds from one sale or redemption while still maintaining the same yield or return. This is difficult to do in times when interest rates are falling.
Of the following, reinvestment risk is most closely associated with A) capital risk B) market risk C) inflation risk D) call risk
D) call risk When interest rates fall, callable securities are likely to be called. While the investor may receive the redemption proceeds sooner than anticipated, it is often difficult to reinvest while maintaining the same level of return due to the lower interest-rate environment. This is why reinvestment risk and call risk can be viewed as being closely associated with each other. Reference: 2.2.1 in the License Exam Manual
The risk that all or a significant portion of the sum invested might be lost is known as A) market risk B) purchasing power risk C) call risk D) capital risk
D) capital risk Particularly when taking aggressive positions, such as in options or DPPs, there is a greater likelihood that a substantial portion of the initial investment can be lost. This is best described as capital risk. Reference: 2.2.2 in the License Exam Manual
The risk when investing, where one has the potential to lose all or part of the investment due to circumstances that are unrelated to the issuer's financial strength or well-being, is known as A) financial risk B) business risk C) call risk D) capital risk
D) capital risk This is the definition of capital risk. For example, capital risk might be least when investing in securities backed by the federal government but much more prevalent when investing in derivative products. Reference: 2.2.2 in the License Exam Manual
Examples of investments in assets that would be considered illiquid would be all of the following EXCEPT A) classic automobiles B) works of art C) real estate D) common stock
D) common stock Investments in stocks and bonds are considered fairly liquid, while investments in fixed assets like real estate, art or collectibles are not, and therefore relatively illiquid.
Holding a callable bond with call protection is least impactful for the investor when A) interest rates are nonvolatile B) interest rates are falling C) interest rates are stable D) interest rates are rising
D) interest rates are rising Bonds are more likely to be called when interest rates are falling. Call protection, a length of time during which the bond cannot be called, protects the investor during these times. Therefore, the call protection is least impactful when interest rates are rising—in other words, least impactful during times when the bond wouldn't likely be called.
If the stock market were to fall substantially in a single day, a portfolio consisting primarily of common and preferred stock would be most subject to A) reinvestment risk B) inflation risk C) regulatory risk D) market risk
D) market risk Market risk is the risk that when the overall market declines, so too will any portfolio made of securities the market is composed of.
Risks that are unique to a specific industry, business type, or investment type are known as A) stock market risk B) systematic risks C) security risks D) nonsystematic risks
D) nonsystematic risks Nonsystematic risks are those that are unique to a specific industry, business enterprise, or investment type.
For investors, instability within an emerging economy is generally recognized as A) currency risk B) regulatory risk C) business risk D) political risk
D) political risk While political risk can be interrelated with legislative risk, most attribute this risk specifically to the potential instability in the political underpinnings of a country or economy. This risk is often associated with emerging economies, though it can potentially exist anywhere.
Purchased 15 years ago with a coupon of 6.25%, a corporate bond in an investor's portfolio has matured. With interest rates now substantially lower at 2.75%, this investor, having no immediate need for the proceeds, is now exposed to A) interest-rate risk B) financial risk C) call risk D) reinvestment risk
D) reinvestment risk The inability to invest proceeds from an investment that had been earning a higher rate of return, at the now current lower rate, is known as reinvestment risk.
An investor has a bond maturing during a time when interest rates are falling. It is likely that the investor, wanting to keep the funds invested, would be most concerned with A) business risk B) purchasing power risk C) inflation risk D) reinvestment risk
D) reinvestment risk When interest rates are declining, it is difficult to invest proceeds from redemptions or distributions and maintain the same level of income one had previously without increasing credit or market risks. This is reinvestment risk.
Sovereign risk is the risk A) that interest rates decline in several countries simultaneously B) of losing all one's investment due to a change in tax laws C) that a dollar earned today will not be able to purchase the same goods or services it can now in the future D) that a country will default on its commercial debt obligations
D) that a country will default on its commercial debt obligations Sovereign risk is when a country is at risk of defaulting on its commercial debt obligations. When this occurs, the impact is felt on financial markets worldwide.
