SIE UNIT 6 Types of Risk

When interest rates are falling, which bonds are most likely to expose holders to call risk? A) Callable bonds with higher coupons B) Callable bonds with lower coupons C) All bonds, regardless of the coupon rate D) All bonds, regardless of whether or not they are callable

A) 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.

Which of the following is a unique risk incurred by investors in mutual funds that specialize in holding securities in the fund portfolio from foreign issuers? A) Currency risk B) Call risk C) Business risk D) Liquidity risk

A) Currency risk

Which of the following accurately characterizes capital risk? A) It can be reduced by diversification. B) It is the potential for loss due to an issuer's financial strength. C) It is always high when investing in government securities. D) It is minimal when investing in derivatives, such as options.

A) 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.

Which of the following has the most liquidity risk? A) Limited partnerships B) Listed REITs C) Treasury bonds D) Stocks listed on NASDAQ

A) Limited partnerships

Regarding investment risks, which of the following is true? A) Safer investments tend to offer lower yields. B) Safer investments come with higher yields. C) Higher yields should be expected when assuming less risk. D) Lower yields should be expected when assuming more risk.

A) 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.

Systematic risk would include all of the following except A) business risk. B) market risk. C) inflation risk. D) interest rate ris

A) business risk. Nonsystematic risks are those associated with the issuer (like a bad business strategy). Systematic risks impact large portions of the market and are difficult to reduce by diversification.

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) call risk, which can lead to reinvestment risk. B) interest-rate risk, which can lead to financial risk. C) business risk, which can lead to financial risk. D) market risk, which can lead to interest-rate risk.

A) 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) cannot be reduced by diversification. B) is often called purchasing power risk. C) occurs when interest rates rise, pushing bond prices higher. D) occurs when interest rates fall, pushing bond prices lower

A) 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.

A strategy that blends various types of investment in an effort to reduce nonsystematic risk is called A) diversification. B) capital preservation. C) sector rotation. D) dollar cost averaging.

A) diversification.

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) market risk. B) inflation risk. C) regulatory risk. D) reinvestment risk.

A) market risk.

The risk that a stock will not appreciate in value due to poor cash flow is an example of A) nonsystematic risk. B) systematic risk. C) market risk. D) sales risk.

A) nonsystematic risk.

Systematic risk is A) not reduced by diversification within an asset class. B) associated with equity investments. C) may be significantly reduced by diversification within an asset class. D) associated with debt instruments.

A) not reduced by diversification within an asset class.

For investors, instability within an emerging economy is generally recognized as A) political risk. B) business risk. C) currency risk. D) regulatory risk.

A) 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.

Which types of investments are most susceptible to interest rate risks? A) Options B) Bonds C) Common stocks D) Money market instruments

B) Bonds

Your customer, Ivan, owns a diversified portfolio of large cap stocks. He would like to find a way to hedge the market risk in his portfolio. Which of these actions might you recommend to accomplish his goal? A) Diversify his portfolio further. B) Buy S&P 500 index puts to hedge market risk. C) Sell all his stocks and wait for a better time. D) Tell him to do nothing because there is no way to mitigate systematic risk

B) Buy S&P 500 index puts to hedge market risk. Your customer is worried about market risk, a systematic risk. Further diversifying his portfolio will not help. Selling everything is likely not helping, and means he may miss any upward moves while he is waiting it out. Derivatives like options (index puts in this case) may be used to offset market risk.

Which type of securities are most susceptible to business risk? A) Corporate bonds B) Common stock C) Money market instruments D) Treasury bonds

B) Common stock Treasury bonds are not at all susceptible to business risk; they are backed by the full faith and credit of the U.S. government. Corporate bonds are mostly subject to financial risk, and money markets are very low risk. Common stocks are most at risk from bad business decisions.

A risk that is specific to a particular issue or issuer is A) is a systematic risk. B) a nonsystematic risk. C) impacts a broad group of securities equally. D) cannot be reduced by diversification.

B) a nonsystematic risk. A risk that is specific to a particular issue or issuer is part of the definition of nonsystematic risk. It may be mitigated by diversification.

Five years ago Thompson, an investor, ran across a board game that he enjoyed and believed the game would become very popular. He purchased 1,000 shares of the corporation that publishes the game. Unfortunately, the game was too complex for most casual game players and sales never amounted to much. Over the five years, the stock of the publisher has remained steady, but has not increased in value. This is an example of A) timing risk. B) business risk. C) social risk. D) regulatory risk.

B) business risk.

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.

Risk that prevails despite diversification within an asset class is A) call risk. B) systematic risk. C) business risk. D) unsystematic risk.

B) systematic risk.

Which of the following statements regarding systematic risk as it relates to an investment portfolio is true? A) Diversification ensures that portfolios are not subject to it. B) Diversification cannot mitigate it to any extent. C) Diversification will not eliminate it. D) Diversification can be used to eliminate it completely.

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.

Investors face many different risks. Which of the following would be factors of systematic risk? I. Decreasing GDP II. Global security threats III. Call risk IV. Net sales A) II and IV B) III and IV C) I and II D) II and III

C) 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. Call risk is dependent on any call features associated with a given security, and net sales are an issue of a company's success. No matter how diversified a portfolio is, it remains subject to systematic risk. An investor cannot diversify systematic risk away.

Kamron owns a diversified portfolio of stocks. The portfolio holds 58 different stocks that are diversified by market capitalization and sector as well as industry. When the stock market entered a significant downward correction Kamron's portfolio also dropped. This is an example of which of these? I. Market risk II. Business risk III. Systematic risk IV. Unsystematic risk A) II and III B) II and IV C) I and III D) I and IV

C) I and III

What is one of the advantages for the investor who invests in mutual funds that include foreign securities in the fund's portfolio? A) Reduced business risk B) Higher dividends C) Increased diversification D) Increased liquidity

C) Increased diversification

Which of the following risks is the risk that congress could change the laws and negatively impact a particular company or industry? A) Sovereign risk B) Regulatory risk C) Legislative risk D) Political risk

C) Legislative risk legislative - Law

Which of the following statements best describes financial risk? A) A risk generally caused by poor management and operating decisions B) The risk that when interest rates decline, it is difficult to invest proceeds from redemptions C) The risk that an issuer will be unable to meet interest and principal payments on debt obligations D) The risk that a security with a call feature might be called before maturity

C) The risk that an issuer will be unable to meet interest and principal payments on debt obligations

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) call risk. B) financial risk. C) business risk. D) reinvestment risk.

C) 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 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) financial risk. B) business risk. C) currency risk. D) liquidity risk.

C) currency risk.

The effect of continually rising retail prices on the investment returns of one's portfolio is best described as A) business risk. B) call risk. C) inflation risk. D) reinvestment risk.

C) 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.

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.

Which of the following would be most susceptible to currency risk? A) Common stock of a small cap company in the United States B) Municipal bonds C) Treasury bonds D) Common stock of a large, well established company in England

D) Common stock of a large, well established company in England

Which of the following is true regarding currency risk? A) It is a systematic risk and, therefore, can be reduced by diversification. B) It is a systematic risk and, therefore, cannot 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. Currency risk is an example of a "borderline" case on its classification as nonsystematic. From the view as a US investor (the default assumption for FINRA exams)currency risk may be mitigated by diversification between domestic and foreign stocks, as well as stocks of companies from different nations. For test purposes it is considered nonsystematic.

Which of the following statements best describes financial risk? A) The risk that when interest rates decline, it is difficult to invest proceeds from redemptions B) A risk generally caused by poor management and operating decisions C) The risk that a security with a call feature might be called before maturity D) The risk that an issuer will be unable to meet interest and principal payments on debt obligations

D) 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.

The inverse relationship between interest rates and bond prices helps in understanding that interest rate fluctuations are A) an example of regulatory risk. B) an unsystematic risk for bonds. C) the difference between credit and financial risk. D) a systematic risk for bonds.

D) a systematic risk for bonds. The inverse relationship illustrates a significant systematic risk for bonds and other fixed-income investments. When rates move up all bonds move down. Credit and financial risk are largely synonymous terms. Interest rate risk is not a regulatory risk.

When investing in overseas markets in foreign securities, investors should be aware of and understand A) business risk. B) market risk. C) reinvestment risk. D) currency risk.

D) currency risk.

Holding a callable bond with call protection is least impactful for the investor when A) interest rates are stable. B) interest rates are falling. C) interest rates are nonvolatile. 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.

New Haven Farms is a producer of specialty foods. They recently received a notice that the Wetlands Maintenance and Drainages Act (The WMD Act) passed indicates that a significant portion of their current land used in food production falls under the act's protection and may no longer be used for agriculture. This is an example of A) political risk. B) regulatory risk. C) business risk. D) legislative risk.

D) legislative risk. The best answer is legislative risk, as this was caused by a change in the law. Regulatory risk is a change in the application of existing rules, while political risk is normally associated with a change in leadership. Business risk would be a bad business plan, not a working business plan damaged by changing laws.

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) financial risk. B) currency risk. C) liquidity risk. D) regulatory risk.

D) 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.

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) financial risk. B) call risk. C) interest-rate 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) purchasing power risk. B) business 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.