Unit 19
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) liquidity risk B) business risk C) purchasing power risk D) interest rate risk
B) business risk 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.
Credit risk is commonly referred to as A) business risk B) default risk C) interest rate risk D) unsystematic risk
B) default risk 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.
A risk-averse client, living in the United States and holding a high proportion of his assets in cash and cash equivalents in U.S. dollars, is exposed to which of the following risks? A) Market risk B) Exchange rate risk C) Purchasing power risk D) Reinvestment rate risk
C) Purchasing power risk Although cash and cash equivalents (money market instruments) may assist in managing liquidity risk, they do have purchasing power, or inflation risk, because they have limited opportunity for capital appreciation. Exchange rate, (currency risk) risk does not apply because this is a U.S. client with investments denominated in dollars. There is no market risk to cash and virtually none to cash equivalents. There is nothing to reinvest with cash, and the returns and maturities on cash equivalents are such that reinvestment risk is not a concern.
The Federal Reserve Board has just taken action leading to an increase in interest rates. Which of the following industries is most likely to be affected adversely by this action? A) Defensive industries B) Cyclical industries C) Utilities D) Heavy industries such as steel
C) Utilities Utility stocks tend to be interest rate sensitive for two reasons. First, they are typically bought for income portfolios, and, as such, changes to interest rates impact their price. Second, because utilities are typically the most highly leveraged of all industries, an increase in interest rates could substantially increase their debt service costs and thus reduce earnings.
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) market risk. B) business risk. C) legislative risk. D) regulatory risk.
C) legislative risk. 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.
Each of the following would be considered a political risk except A) coups. B) terrorism. C) nationalization of private industries. D) adverse weather conditions.
D) adverse weather conditions. Explanation There is no evidence that political entities can change weather conditions. Nationalization of private industries is a political decision and terrorism and coups are considered political risks.
Among the advantages of being the holder of secured bond is that if the issuer files for bankruptcy, you A) are sure to recover 100% of your investment B) will receive your principal plus all unpaid interest C) are paid ahead of everyone, except past-due wages to employees D) are paid ahead of holders of unsecured debt, as well as equity securities
D) are paid ahead of holders of unsecured debt, as well as equity securities Explanation Secured bondholders are on the top of the list of creditors. The first priority for unsecured claims is that of employees and taxes. Even with a secured claim, there is no assurance that you will receive all your money back (think of the "short sales" on homes not long ago where the bank accepted less than the mortgage amount because the value of the home had fallen so far).
A conservative investor decides to invest in high quality corporate bonds paying 5% instead of investing in lower quality bonds paying 9%. The additional 4% return the investor could have potentially earned on the lower quality bonds represents A) opportunity cost. B) marketability costs. C) purchasing power costs. D) liquidity costs.
A) opportunity cost. Anytime an investor makes an investment, he is automatically precluded from investing that same money anywhere else. The potential additional earnings an investor might have earned from an alternative investment is known as opportunity cost.
If a customer is concerned about interest rate risk, which of the following securities is least appropriate? A) 5-year corporate bonds B) 25-year municipal bonds C) 10-year corporate bonds D) Treasury bills
B) 25-year municipal bonds Interest rate risk is the danger that interest rates will rise and adversely affect a bond's price. This risk is greatest for long-term bonds; short-term debt securities are affected the least if interest rates change.
The debt obligations of a company that has issued securities to fund its expansion are considered an example of what type of investment risk? A) Market risk B) Reinvestment rate risk C) Credit or default risk D) Purchasing power risk
C) Credit or default risk A company using borrowed capital to expand is increasing its financial leverage. As such, the possibility of default increases. Investors can reduce their risk either by diversifying into companies using minimal leverage or selecting those issuers with higher credit ratings. The other risks noted are systematic or nondiversifiable risk.
Which of the following is the risk that diminishes through portfolio diversification? A) Purchasing power risk B) Systematic risk C) Unsystematic risk D) Interest rate risk
C) Unsystematic risk Unsystematic risk (diversifiable risk) is the risk that is eliminated when the investor builds a well-diversified portfolio. Interest rate risk and purchasing power risk are examples of systematic (nondiversifiable risk).
A country decides to nationalize its sugar industry. This is an example of A) business risk. B) financial risk. C) political risk. D) sovereign risk.
C) political risk. The decision to take over private enterprise is a political one. The nationalization of the sugar industry happened in Cuba after the Castro regime took over. Business risk is generally related specifically to actions taken by the company, such as bad management decisions. Financial risk is also company related, such as when the company incurs more debt than it can handle. Sovereign risk is when the investment is made in the country itself (buying its bonds) not private enterprise.
Liquidity risk would be greatest for an investor whose portfolio was primarily composed of A) Nasdaq stocks. B) municipal bond UITs. C) ADRs listed on the NYSE. D) municipal bonds.
D) municipal bonds. Explanation 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.
Which of the following statements best defines inflation risk? A) The uncertainty that the value of an investor's assets will decrease as measured by real dollar purchasing power B) The uncertainty that the nominal return of an investment will not outpace the overall market C) The uncertainty that a given amount invested today in a fixed income instrument will not generate the same nominal income in the future D) The uncertainty that one will not receive back an equal amount of principal in the future
A) The uncertainty that the value of an investor's assets will decrease as measured by real dollar purchasing power Inflation risk is the uncertainty that an investment's purchasing power will decrease due to the shrinking value of the currency. An investor's real rate of return is the nominal rate less the inflation rate.
An investor's portfolio that consists of all long-term Treasury bonds is most vulnerable to which of the following types of risk? A) Interest rate risk B) Marketability risk C) Default (credit) risk D) Business risk
A) Interest rate risk The client is most exposed to interest rate risk because a rise in interest rates would cause a decline in the value of the long-term bonds. This client is also exposed to inflation, or purchasing power risk. There is very little marketability (liquidity) risk and no-default (credit) risk.
An investment adviser is meeting with an elderly client whose portfolio consists largely of fixed-income investments. Over the past several years, she has been losing purchasing power. As a result, it would be important to inform her of A) opportunity risk B) inflation risk C) liquidity risk D) market risk
B) inflation risk Fixed-income investments are subject to purchasing power risk, also called, inflation risk.
From first to last, in what order would claimants receive payment in the event of bankruptcy? A) Preferred stockholders, secured debt, general creditors, subordinated debentures B) Secured debt, subordinated debentures, general creditors, preferred stockholders C) Secured debt, general creditors, subordinated debentures, preferred stockholders D) Subordinated debentures, preferred stockholders, general creditors, secured debt
C) Secured debt, general creditors, subordinated debentures, preferred stockholders The liquidation order is as follows: secured debt holders, unsecured debt holders (including general creditors), holders of subordinated debt, preferred stockholders, and common stockholders.
U.S. Treasury bonds are generally subject to all of the following risks except A) purchasing power risk. B) reinvestment risk. C) inflation risk. D) liquidity risk.
D) liquidity risk. Explanation The market for U.S. Treasury bonds is highly liquid. As safe and as liquid as they are, they, like all fixed-income investments, are subject to purchasing power (also known as inflation) risk and reinvestment risk.
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) financial risk. B) business risk. C) regulatory risk. D) market risk.
D) market risk. Explanation 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
A risk-averse client, living in the United States, holding a high proportion of his assets in cash and cash equivalents in U.S. dollars, is exposed to which of the following risks? A) Market risk B) Purchasing power risk C) Reinvestment rate risk D) Exchange rate risk
B) Purchasing power risk Although cash and cash equivalents (money market instruments) may assist in managing liquidity risk, they do have purchasing power, or inflation risk, because they have limited opportunity for capital appreciation. Exchange rate (currency risk) risk does not apply because this is a U.S. client with investments denominated in dollars. There is no market risk to cash and virtually none to cash equivalents. There is nothing to reinvest with cash and the returns and maturities on cash equivalents are such that reinvestment risk is not a concern.
Which of the following describes unsystematic risk? A) It is specific to an investment and can be diversified away. B) It is related to market forces and can be diversified away. C) It is specific to an investment and cannot be diversified away. D) It is related to market forces and cannot be diversified away.
A) It is specific to an investment and can be diversified away. 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.
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) market risk C) purchasing power risk D) money-rate risk
A) business risk 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.
If your client is primarily concerned about the rising cost of living but wishes to limit his exposure to business risk, which of the following securities is most appropriate? A) AAA intermediate-term corporate bond fund B) Tax-free municipal bond fund C) S&P 500 index fund D) Small-cap stock fund
C) S&P 500 index fund Business risk is an unsystematic, or diversifiable, risk. Therefore, the correct choice should be a diversified portfolio. Before we make our final decision, we also must take into consideration that the investor is concerned about inflation risk, a systematic risk. Inflation, or purchasing power, risk is found predominantly with fixed-income securities such as bonds while equity securities are the traditional hedge against inflation. Putting all the information together, we eliminate the bond funds because they will not offer inflation protection and of the two equity choices, the S&P 500 index fund consists of large-cap companies which tend to have less overall business risk than small-cap stocks.
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) 75% S&P 500 index ETF; 25% municipal bond UIT D) 50% U.S. Treasury bonds, average maturity 20 years; 30% U.S. Treasury notes, average maturity five years; 20% 90-day Treasury bills
D) 50% U.S. Treasury bonds, average maturity 20 years; 30% U.S. Treasury notes, average maturity five years; 20% 90-day Treasury bills Explanation 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.
If you had expectations of high inflation, you would A) increase fixed-income exposure and reduce equity exposure B) increase equity exposure and reduce fixed income exposure C) increase fixed-income exposure and reduce commodity exposure D) increase fixed-income exposure and reduce tangible asset exposure
B) increase equity exposure and reduce fixed income exposure Rising inflation will reduce real returns on fixed-income investments, so you would want to reduce that exposure. Equities, tangible assets, and commodities tend to increase along with the inflation rate.
Which of the following will be the most likely risk that you will face during the first year after purchasing a corporate AA bond that matures in 15 years? A) Credit B) Interest rate C) Market D) Liquidity
B) Interest rate With 15 years to maturity, even an investment-grade bond is subject to interest rate risk. This is particularly true during the early years because price fluctuations are greater when duration is longer. Credit risk is not a concern with AA bonds over a period of only one year, and AA bonds generally possess better-than-average liquidity. For this exam, market risk usually applies to equity securities rather than debt.
A risk-averse client, living in the United States and holding a high proportion of his assets in cash and cash equivalents in U.S. dollars, is exposed to which of the following risks? A) Market risk B) Reinvestment rate risk C) Purchasing power risk D) Exchange rate risk
C) Purchasing power risk Although cash and cash equivalents (money market instruments) may assist in managing liquidity risk, they do have purchasing power, or inflation risk, because they have limited opportunity for capital appreciation. Exchange rate, (currency risk) risk does not apply because this is a U.S. client with investments denominated in dollars. There is no market risk to cash and virtually none to cash equivalents. There is nothing to reinvest with cash, and the returns and maturities on cash equivalents are such that reinvestment risk is not a concern.
Prior to the opening of the securities markets, KAPCO Chemical Corporation reports quarterly earnings per share of $1.50, exceeding analysts' estimates by more than 10%. By the end of the trading session, KAPCO's stock price has fallen by 5%. This would be an example of A) opportunity cost B) market risk C) financial risk D) regulatory risk
B) market risk Market risk is the uncertainty that a stock's price will move in a manner unrelated to the company's fundamentals. A prime example of this is when earnings go one way and the stock price goes the other. What we are not told in the question is the performance of the stock market. It is likely that the overall market has declined over this period. Financial risk is, as the name indicates, related to financing circumstances. The most common financial risk is when excess leverage has been employed. Another financial risk is lack of cash flow, but nothing in this question indicates that situation.
If a pharmaceutical manufacturer's stock declines because the federal Food and Drug Administration has doubled the period of time required for clinical trials before any new drug may be released for public sale, this is an example of A) business risk B) regulatory risk C) beta risk D) inflation risk
B) regulatory risk Regulatory risk represents actions of government regulators that limit activities of businesses or add to their costs. The FDA's refusal to approve a new drug as quickly as it used to presents regulatory risk to the holder of the company's securities.
One of your clients owns shares of the NERP Corporation's senior preferred stock. He is concerned about NERP's financial solvency and wonders where he would fall in the event of NERP declaring bankruptcy. The proper response is, the client's claim is A) after the secured creditors, but ahead of the unsecured creditors because of the senior claim. B) ahead of all claims because his stock has a senior claim. C) after the creditors, but ahead of the common stockholders. D) after the creditors and the common stockholders.
C) after the creditors, but ahead of the common stockholders. In a corporate bankruptcy, the first claim is that of secured creditors. They are followed by the unsecured creditors. After all creditors have been satisfied, any remaining funds are used to pay off the preferred stock up to its par value, and finally, if there is anything left, it goes to the common stockholders. When a preferred stock is named as a senior preferred, it generally means that there is more than one class of preferred stock outstanding and this one has priority over the others.
The MNO Manufacturing Company, headquartered in Springfield, has just filed for bankruptcy. Under federal bankruptcy law, holders of which of the following would have highest priority with the bankruptcy trustee? A) Class A common stock B) Guaranteed bonds C) First lien, senior preferred stock D) Mortgage bonds
D) Mortgage bonds Explanation Holders of a bond secured by mortgages on real property are senior creditors and have the highest priority claim in a bankruptcy. Guaranteed bonds have their principal (and interest) guaranteed by a party other than the issuer. The guarantee is only as strong as the guarantor and, because there is no collateral securing the obligation, these are in the category of general creditors. No matter how many adjectives are placed ahead of preferred stock, it always comes after everyone else who is owed money. Common stock, regardless of class, is always the last in line.
An investor has bonds maturing in three weeks on the first day of the upcoming month. Since his purchase of the bonds five years ago, interest rates have fallen. To which one these risks are these bonds most likely to be subject? A) Default risk B) Interest rate risk C) Purchasing power risk D) Reinvestment risk
D) Reinvestment risk Explanation Reinvestment risk is the risk associated with reinvesting interest and/or principal payments when interest rates have fallen. On the upcoming maturity date, the investor will receive the par value of the bonds plus the final interest payment. When looking to reinvest the proceeds, it will be at current market interest rates which, as the question states, are lower than what the bonds had been paying.
Steve and Haley, ages 48 and 45, respectively, invest in large-cap stocks, international stock mutual funds, and real estate. They consider themselves moderately aggressive investors. Their investment portfolio is subject to all of the following risks except A) systematic risk. B) business risk. C) currency risk. D) default risk.
D) default risk. Explanation Their investment portfolio is subject to all of these risks except default risk. Default risk primarily applies when holding debt securities. A portfolio heavily concentrated in equity securities is going to have market (systematic) risk. Business risk is the risk that a company's managerial decisions or even factors out of its control, such as expiration of a patent, may negatively affect the value of an equity investment. By holding investments in international stock mutual funds, they are subject to exchange rate risk.
