Types of Investment Risks 11

Calvin has the following securities in his portfolio: ABC common stock, XYZ common stock, PQR mutual fund (domestic small cap), DEZ mutual fund (foreign small cap), 30-year Treasury bond, and 5-year Treasury note. Which of the following risks should not concern Calvin? A) Default risk B) Reinvestment rate risk C) Financial risk D) Systematic risk

A) Default risk Default risk only applies to debt securities and Treasuries (at least on the exam) and are considered default risk free. Financial risk is the uncertainty introduced from the method by which a firm finances its assets (i.e., debt vs. equity financing). Reinvestment rate risk is the risk that as cash flows are received they will be reinvested at lower rates of return than the investment that generated the cash flows. Systematic risk is the risk that all securities are subject to and typically cannot be eliminated through diversification.

An investor is analyzing the impact of the specific type of risk affecting bonds because the fixed cash payments that they deliver may become less valuable. What risk is this? A) Inflation risk B) Systematic risk C) Interest rate risk D) Credit risk

A) Inflation risk This is an example of a question where careful reading is necessary. Indeed, every one of the choices is a risk faced by bond investors, but only one specifically answers the question. When the semiannual interest payments 10 or 20 years from now don't buy as much as they would today, that is inflation or purchasing power risk. That falls into the category of systematic risk. On the exam, when one choice is specific and the other is broad, go with the specific one. Interest rate risk is another systematic risk, but it indirectly relates to the question. Credit risk is an unsystematic risk and has nothing to do with the issue raised here.

Which of the following would constitute political risk that might affect a security? A) New tariffs are levied against the company's major product B) A bad decision by the company's CEO C) New environment regulations D) A strike by the union representing the company's employees

A) New tariffs are levied against the company's major product Political risk involves political activities, and of the choices given, the only one that is the result of actions by a political body is the decision to raise tariffs. A strike has nothing to do with politics (theoretically), and environmental regulations create regulatory risk.

You have a 45-year-old client wishing to save for retirement. The client does not have a great deal of investment sophistication and inquires about the risks you have exposed him to by placing the majority of his portfolio in listed common stocks. You would respond that one risk he should not concern himself with is: A) liquidity risk B) systematic risk C) business risk D) inflation risk

A) liquidity risk A portfolio of listed common stocks will have little to no liquidity risk because listed shares are easily traded. Even though common stock tends to offer protection against inflation, there is no assurance that the portfolio will keep pace with the rising cost of living.

An investor buys a promising common stock expecting a return of 10%, while a 6% return is available in risk-free Treasury bills. In actuality, the common stock only returns 3%. By giving up the risk-free return to speculate on the stock, the investor has encountered A) spread B) opportunity cost C) yield curve D) interest expense

B) opportunity cost An opportunity cost is the return given up for an alternative investment when a risk-free choice is not made. In this instance, the opportunity cost is the 3% difference between what could have been earned and what was actually earned. Spread typically describes bond-yield differences or the difference between a bid and an offer for a security. There is no interest spent, only an interest rate foregone in the effort to earn a return on the stock. The yield curve is the difference in yields among similar-quality bonds with different maturities.

If interest rates are dropping, an investor with a maturing bond will be most concerned with A) a positive yield curve a B) negative yield curve C) the difficulty in finding another investment with a like yield D) the quality declining with the yield

C) the difficulty in finding another investment with a like yield When interest rates decline, investors with maturing bonds will have to accept a lower return on their reinvested principal. This is often called reinvestment risk. Although zero-coupon bonds avoid this risk until maturity, once the bond matures, just like any other bond, the matured principal will have to be invested at current market yields

Because of the decline in sales revenues, a company that had forecast an earnings growth of 25% now forecasts growth of only 12%. This is an example of what type of risk in the investment of securities? A) Market risk B) Interest rate risk C) Purchasing power risk D) Business risk

D) Business risk In this question, we have a company that did not perform as it had anticipated, which represents the business risk of investing in this particular security. The fact that their earnings growth was only half their original projections had nothing to do with the market. Interest rate risk applies to the uncertainty that the market price of a security might change solely due to the changes in the cost of money. Purchasing-power risk is the uncertainty that a dollar will represent less buying power in the future.

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) reinvestment risk C) financial risk D) market risk

D) market risk 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.