Unit 19: Types of Investment Risks
Which of the following risks would be associated with long-term, AAA-rated bonds? A) Purchasing power risk B) Marketability C) Unstable interest payments D) Ability of the issuing company to pay interest and principal
A) Purchasing power risk AAA-rated debt 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.
The potential for the market price of common stock in the ABC Corporation to fluctuate due to its tendency to move with all securities of the same type represents what kind of risk? A) Interest rate B) Business C) Market D) Inflation
C) Market Changes in the market price of common stock due to movement in the market, rather than changes in the underlying business, is known as market risk. This is why it is a systematic risk. Inflation risk and interest rate risk are also systematic risks, but their effect is primarily on fixed income securities rather than common stock.
As interest rates rise, the opportunity cost of holding cash A) equals the risk-free rate. B) remains the same. C) decreases. D) increases.
D) 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.
You recently took a trip to Warsaw, Poland, and when you received your credit card statement, you noticed that your vodka purchase for 100 Polish Zlotys resulted in a $30 charge on your statement. Based on this exchange rate, each dollar was worth approximately A) 3.33 Zlotys B) 3 Zlotys C) $3.33 D) $.33
A) 3.33 Zlotys When making an investment (or a transaction) in a foreign currency, it is important to be able to translate that into the exchange rate for your home currency. To do so, we divide the purchase in the foreign currency by the charge in U.S. dollars. In this case, 100 Zlotys only cost us $30, so that makes each dollar worth 3.3 Zlotys.
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) S&P 500 index fund B) Small-cap stock fund C) AAA intermediate-term corporate bond fund D) Tax-free municipal bond fund
A) 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.
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) legislative risk. B) regulatory risk. C) business risk. D) market risk.
A) 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.
When deciding on the suitability of a particular investment, that client's need for liquidity is A) not a significant consideration B) an important consideration when determining the suitability of an investment C) only significant if the individual is planning on retirement D) only important if the client has no other liquid investments
B) an important consideration when determining the suitability of an investment Liquidity is extremely important when determining suitability for a client.
If your client's entire investment portfolio consists of his company's employee stock ownership plan and stock in the company acquired under the executive stock option program, the client's portfolio is most exposed to A) inflation risk B) business risk C) interest rate risk D) market risk
B) business risk Because the client's investment (and indeed his employment) is entirely invested in his employer's stock, his portfolio is disproportionately exposed to business risk. Should the company experience a business or industry setback, the portfolio could suffer substantial losses. There are a large number of historical examples where this has happened (frequently wiping out retirement savings).
What is most likely to happen to outstanding fixed-income securities when interest rates decline? A) Coupon rates go up B) No change C) Prices go up D) Yields go up
C) Prices go up When interest rates drop, prices will rise, decreasing effective yield. Thus, there is an inverse relationship between interest rates and bond prices.
Which of the following statements regarding investment risk is not correct? A) Investors expect to earn a higher rate of return for assuming a higher level of risk. B) The beta coefficient measures an individual stock's relative volatility to the market. C) Systematic risk may be reduced or eliminated by effective portfolio diversification. D) A stock's level of risk is a combination of market risk and diversifiable risk.
C) Systematic risk may be reduced or eliminated by effective portfolio diversification. Unsystematic (diversifiable) risk may be effectively managed through portfolio diversification. It is systematic risk where diversification has little effectiveness.
The major risk for highly rated corporate bonds is A) liquidity B) tax law changes C) interest rate changes D) stock market volatility
C) interest rate changes Because rising interest rates cause the prices of all bonds to decline, interest rate changes are the major risk factor for bonds. The bond market sometimes moves in the opposite direction to the stock market (negative correlation).
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) beta risk C) regulatory risk D) inflation risk
C) 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.
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) Liquidity C) Market D) Interest rate
D) 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.
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) market risk C) liquidity risk D) inflation risk
D) inflation risk Fixed-income investments are subject to purchasing power risk, also called, inflation risk.
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) market risk B) credit risk C) business risk D) legislative risk
D) 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.
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 one will not receive back an equal amount of principal in the future C) The uncertainty that the nominal return of an investment will not outpace the overall market D) The uncertainty that a given amount invested today in a fixed income instrument will not generate the same nominal income 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.
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) market risk. B) business risk. C) regulatory risk. D) financial risk.
A) 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
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) liquidity costs. D) purchasing power 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.
Despite management's best efforts, a corporation with stock traded publicly on the New York Stock Exchange has had to declare bankruptcy and is being forced to liquidate its assets. The liquidation priority is determined by A) the seniority of the claim. B) last-in, first-out (LIFO). C) the Securities and Exchange Commission (SEC). D) the date of the claim.
A) the seniority of the claim. The seniority of the claim refers to senior (secured) debt which has the highest priority among security holders in a bankruptcy case. The SEC (or the exchange) has nothing to do with it; we're dealing with federal (sometimes state) bankruptcy law.
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) Reinvestment rate risk B) Default risk C) Business risk D) Systematic risk
B) Default risk Default risk applies only to debt securities. That is, one can default only on a debt (failure to pay the interest when due and/or the principal). For exam purposes, there is one category of debt securities that has no default risk: securities issued by the U.S. Treasury. Therefore, with a portfolio consisting of nothing but equity securities and Treasuries, default risk would not be a concern to Calvin. Business risk is the uncertainty that a corporation will underperform, either due to management failures or some other event unique to that company or industry. That is certainly a concern with the investments in ABC and XYZ common stock. To a lesser degree (because of the diversification), business risk also applies to ownership of mutual funds. 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 and applies largely to any debt security. Systematic risk is the risk that all securities are subject to and typically cannot be eliminated through diversification.
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) Guaranteed bonds B) Mortgage bonds C) First lien, senior preferred stock D) Class A common stock
B) Mortgage bonds 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.
Which of the following statements regarding the risks inherent in bonds is most accurate? A) Price risk refers to the decrease in bond prices as interest rates fall. B) The reinvestment rate assumption in calculating bond yields is generally not significant to the bond's yield. C) Interest rate risk is the risk that the bond's coupon rate will be adjusted downward if market rates decline. D) Default risk deals with the likelihood that the issuer will fail to meet its obligation to pay interest and/or principal.
B) The reinvestment rate assumption in calculating bond yields is generally not significant to the bond's yield. As is the case with any debt, the lender is always concerned that the borrower will default. This risk does not apply to U.S. Treasury securities (at least for exam purposes). One way to minimize this risk is by limited exposure to debt with higher credit ratings. Once the bond's coupon (interest) rate has been set, it doesn't change with changes to market interest rates. There are adjustable rate debt instruments available, but, unless the question specifically refers to them, disregard that possibility. Reinvestment is crucial to bond yield, and interest rate risk is the risk of changes in a bondholder's return due to changes in a bond's yield. Price risk, also referred to as market risk, refers to the decrease (increase) in bond prices as interest rates rise (fall).
Specific or unsystematic risk refers to investment risk that is A) due to fundamental risk factors B) diversifiable C) due to the market measure of risk D) undiversifiable
B) 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.
In October 1987, ABC Manufacturing Company showed a strong balance sheet. Nevertheless, its stock lost 15 points in the "crash of 1987." This is an example of A) beta B) market risk C) opportunity risk D) business risk
B) market risk Market risk is the risk that a specific stock's price will be driven by factors largely independent of its issuer. Business risk is unique to each business entity. Beta is a measure of a stock's volatility relative to the overall market. The question does not refer to the volatility or sensitivity of the stock to the overall market. Opportunity risk is not among the recognized sources of risk. Opportunity cost is a term in economics that refers to the return given up in order to invest in another instrument or project.
Liquidity risk would be greatest for an investor whose portfolio was primarily composed of A) Nasdaq stocks. B) municipal bonds. C) municipal bond UITs. D) ADRs listed on the NYSE.
B) 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.
The STU Corporation has issued common stock, preferred stock, promissory notes, and mortgage bonds. Should STU enter bankruptcy proceedings, the order of payment against claims would be A) the mortgage bonds, the preferred stock the common stock, and the promissory notes. B) the mortgage bonds, the promissory notes, the preferred stock, and the common stock. C) the preferred stock, the common stock, the mortgage bonds, and the promissory notes. D) the promissory notes, the mortgage bonds, the preferred stock, and the common stock.
B) the mortgage bonds, the promissory notes, the preferred stock, and the common stock. In a bankruptcy, secured creditors, such as those with a mortgage against real property, have the first priority. They are followed by unsecured creditors, such as holders of promissory notes, with stockholders coming last. Preferred stock is "preferred" over common in both liquidation priority and payment of dividends.
Which of the following portfolios would most likely be exposed to the most inflation risk? A) 75% S&P 500 index ETF; 25% municipal bond UIT B) 100% employer's company stock C) 50% U.S. Treasury bonds, average maturity 20 years; 30% U.S. Treasury notes, average maturity five years; 20% 90-day Treasury bills D) 34% diversified common stocks; 33% long-term convertible debentures; 33% non-cumulative preferred stock
C) 50% U.S. Treasury bonds, average maturity 20 years; 30% U.S. Treasury notes, average maturity five 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.
From first to last, in what order would claimants receive payment in the event of bankruptcy? A) Secured debt, subordinated debentures, general creditors, preferred stockholders B) Subordinated debentures, preferred stockholders, general creditors, secured debt C) Secured debt, general creditors, subordinated debentures, preferred stockholders D) Preferred stockholders, secured debt, general creditors, subordinated debentures
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.
John purchased stock of a company in the business of manufacturing yachts. Two years ago his securities had lost most of their value as a result of a congressionally imposed luxury tax on purchases of more than $30,000. John's investment in the yacht-building business suffered a loss due to A) regulatory risk B) business risk C) legislative risk D) volatility
C) legislative risk John's investment in the yacht-building business suffered a loss as a result of legislative risk. In other words, the rules of the game (i.e., tax treatment) changed after John purchased the security as a result of legislative action.
A country decides to nationalize its sugar industry. This is an example of A) sovereign risk. B) financial risk. C) business risk. D) political risk.
D) 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.
A general risk component representing the variability of a stock's total return as it directly relates to overall movements in the general economy is known as A) business risk. B) political risk. C) financial risk. D) systematic risk.
D) systematic risk. Systematic risk, also referred to as market risk, is the variability in a stock's total return that is directly associated with overall movements in the general economy and cannot be eliminated through diversification. The other 3 choices are all unsystematic risks.
