UNIT #11: Types of investment risks
A portfolio that is primarily invested in corporate bonds would be subject to 1. credit risk 2. interest rate risk 3. opportunity cost 4. purchasing power risk A) I, II, III, and IV B) I, II, and IV C) I and II D) II and IV
A) 1, 2, 3 & 4 *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.
The term used to describe the risk that affects all securities is A) financial risk B) systematic risk C) overall risk D) unsystematic risk
B) Systematic Risk *Systematic risk is used to describe the risk associated with investing in the market (system). You should note that beta measures the volatility of a security (or portfolio) relative to the market and can assist you in judging how much a security will react to systematic risk.
If a customer is concerned about interest rate risk, which of the following securities is least appropriate? A) 25-year municipal bonds B) Treasury bills C) 5-year corporate bonds D) 10-year corporate bonds
A) 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.
Which of the following risks would be associated with long-term, AAA-rated bonds? A) Purchasing power risk B) Marketability C) Ability of the issuing company to pay interest and principal D) Unstable interest payments
A) Purchasing power risk *AAA-rated, long-term securities are the highest available quality as far as default or credit risk is concerned. It is highly unlikely that the company would be unable to pay their interest and principal payments on time. Because of their safety, the marketability of the bonds should be strong. However, like all fixed dollar investments, they are subject to purchasing power (inflation) risk. You may wish to note that these bonds would also be subject to interest rate risk.
Specific or unsystematic risk refers to investment risk that is A) due to the market measure of risk B) undiversifiable C) diversifiable D) due to fundamental risk factors
C) Diversifiable *Specific risk is risk that is unique to a business or an asset. Specifically, the risk of any asset is offset by the unique variability of the other assets in the portfolio. Systematic risk is risk that is undiversifiable and is caused by common macroeconomic variables.
Whippet Bus Lines, Inc., serving most of the country, has just been informed by the Surface Transportation Board of the United States that all of its buses must be retrofitted with expensive safety equipment. The effect of this will be a significant drop in Whippet's net income. To an investor in Whippet Bus Lines, Inc., this would be an example of A) market risk. B) business risk. C) country risk. D) regulatory risk.
D) Regulatory Risk *When an action by a regulatory agency, such as the STB, leads to increased costs and lower income, that is regulatory risk.
Each of the following would be considered a political risk except A) coups. B) adverse weather conditions. C) nationalization of private industries. D) terrorism.
B) Adverse weather conditions *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.
U.S. Treasury bonds are generally subject to all of the following risks except A) purchasing power risk. B) inflation risk. C) reinvestment risk. D) liquidity risk.
D) Liquidity risk *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.
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) Small-cap stock fund B) AAA intermediate-term corporate bond C) Tax-free municipal bond D) S&P 500 index fund
D) S&P 500 index fund *S&P index funds are growth-oriented investment vehicles that have traditionally outpaced inflation and, because of their diversification, tend to limit business risk. Small-cap stock funds should also outpace inflation but carry too much risk for a client who wishes to limit business risk. Bonds, whether corporate or municipal, as fixed income investments, are generally not suitable for clients whose primary concern is protecting themselves against the rising cost of living.
As interest rates rise, the opportunity cost of holding cash A) remains the same. B) equals the risk-free rate. C) increases. D) decreases.
C) Increases *At higher interest rates, the opportunity cost of holding cash increases, and firms and households will desire to hold less cash and more interest-bearing financial assets.
Which of the following portfolios would most likely be exposed to the most inflation risk? A) 34% diversified common stocks; 33% long-term convertible debentures; 33% non-cumulative preferred stock B) 75% S&P 500 index ETF; 25% municipal bond UIT 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) 100% employer's company 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 *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.
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) regulatory risk C) market risk D) financial risk
C) Market Risk *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
Liquidity risk would be greatest for an investor whose portfolio was primarily composed of A) Nasdaq stocks B) ADRs listed on the NYSE C) municipal bonds D) municipal bond UITs
C) Municipal Bonds *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.
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) duration risk B) purchasing power risk C) market cost D) opportunity cost
D) Opportunity cost *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.
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) yield curve B) spread C) interest expense D) opportunity cost
D) 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.
An investor who is in search of greater return has a portfolio overconcentrated in speculative OTC Bulletin Board and OTC Link stocks. This investor's risk is best reduced through A) diversification B) reducing his time horizon C) arbitrage D) hedging with broad-based put options
A) Diversification *A portfolio like this is exposed to a high degree of unsystematic (business) risk. The best method of protection is through diversification. Hedging with broad-based options would not work because they don't correlate to this portfolio. A longer time horizon allows the investor to ride out the ups and downs these stocks may have, and arbitrage has no meaning in this context
A country decides to nationalize its sugar industry. This is an example of A) political risk. B) sovereign risk. C) financial risk. D) business risk.
A) 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.
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) business risk B) legislative risk C) regulatory risk D) market risk
B) 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.
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) purchasing power costs B) opportunity cost C) liquidity costs D) marketability costs
B) 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.
A company using debt obligations to finance business expansion is indicative of what type of investment risk? A) Market risk B) Purchasing power risk C) Credit or default risk D) Reinvestment rate 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.
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) Subordinated debentures, preferred stockholders, general creditors, secured debt C) Secured debt, general creditors, subordinated debentures, preferred stockholders D) Secured debt, subordinated debentures, general creditors, preferred stockholders
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.
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) financial risk B) market risk C) regulatory risk D) opportunity cost
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.
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) Interest rate B) Inflation C) Liquidity D) Market
D) Interest rate risk *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. Inflation risk is not very great over a period of only 1 year, and AA bonds generally possess better-than-average liquidity. For this exam, market risk usually applies to equity securities rather than debt.
The uncertainty resulting from the possibility that the value of an investment will be affected by a change in the law is known as A) credit risk B) market risk C) legislative risk D) business risk
C) Legislative Risk *The possibility that the value of an investment will be affected by changes in government laws is known as legislative risk. Market risk is the risk that the value of an investment will decrease because of changes in the market price of the investment. Business risk is the uncertainty about the prospects of the company that issued the security, while credit risk involves the possibility that the issuing company will be unable to repay its debt obligations.
The MNO Manufacturing Company, headquartered in Springfield, has just filed for bankruptcy. Under federal bankruptcy law, which of the following would have highest priority with the bankruptcy trustee? A) Holders of mortgage bonds B) Holders of first lien, senior preferred stock C) Employee wages earned within the 180 days prior to the bankruptcy filing D) Property taxes owed to the city of Springfield
A) Holders of mortgage bonds *Holders of mortgages on real property securing a bond are senior creditors and have the highest priority claim in a bankruptcy. Under federal bankruptcy law, there are several categories of unsecured claims that have a higher priority than other unsecured ones, but secured debt always comes first. Two of the most common high ranking unsecured claims are employee wages as long as the wages were earned during the 180 days prior to the bankruptcy filing, and certain taxes. No matter how many adjectives are placed ahead of preferred stock, it always comes after everyone who is owed money.
All of the following are examples of unsystematic risk EXCEPT A) purchasing power risk B) financial risk C) political risk D) tenure risk
A) Purchasing power risk *Unsystematic risk, also known as diversifiable risk, affects only a particular company, country, or sector and its securities. Purchasing power risk is an example of systematic risk that affects the certainty of returns associated with any investment—most particularly, fixed income. Political and financial risk would be considered unsystematic and there is no formal classification known as tenure risk, although some mutual funds whose advisers have a short tenure, might be considered to have that kind of risk. If that were to be considered, it would still be an unsystematic risk.
The issuer-specific component of the variability in a stock's total return that is unrelated to overall market variability is known as A) systematic risk. B) fundamental risk. C) nondiversifiable risk. D) unsystematic risk.
D) unsystematic risk *Unsystematic risk is unique to a single security, business, industry, or country and may be reduced by diversification. Systematic risk is related to the overall market or economy and is not diversifiable.
Among the provisions of the Investment Company Act of 1940 designed to protect the interests of investors is the provision that A) selection of company investments must be approved by SEC B) any change in fundamental investment policy must be approved by stockholders C) communications with the public must be approved by FINRA before its use D) for diversification purposes, an investment company may own up to 10% of the shares of another investment company
B) any change in fundamental investment policy must be approved by stockholders *One of the requirements of the Investment Company Act of 1940 is that an investment company cannot change its investment policy without approval of a majority vote of the shareholders. For example, the board of directors of a growth fund could not change the fund's investment objective to income without that approval. This has the effect of offering protection to the investors that they won't be "blindsided" by the board or the portfolio manager. On this exam, you shouldn't expect to see anything "approved" by the SEC as a correct answer. An investment company may own up to 3% of another investment company, not 10%. Even though FINRA rules do require approval of investment company communications with the public, such approval is not part of the Investment Company Act of 1940.
