Unit 11

One of the risks found in equity investing is known as unsystematic risk. The most common way to reduce this risk is? A) Diversification B) Specialization C) Reducing the beta coefficient D) Increasing the positive correlation

A) Diversification Unlike systematic (market) risk, unsystematic or nonsystematic risk can be reduced through diversification.

liquidation priority

1. secured debt 2. general creditors 3. subordinated debt 4. preferred stockholders 5. common stockholders

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) opportunity cost B) purchasing power risk C) market cost D) duration risk

A) 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.

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) Interest rate risk B) Business risk C) Purchasing power risk D) Market risk

B) 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.

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) systematic risk B) liquidity risk C) business risk D) inflation risk

B) 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.

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) currency risk. C) default risk. D) business risk.

C) default risk. 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.

If a customer is concerned about interest rate risk, which of the following securities is least appropriate? A) 10-year corporate bonds B) 5-year corporate bonds C) Treasury bills D) 25-year municipal bonds

D) 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 2 are most associated with a U. S. Treasury bond? I. Credit risk II. Liquidity risk III. Reinvestment risk IV. Interest rate risk

III and IV We negate credit risk when it comes to U.S. Treasury securities. Liquidity is also not an issue. However, any interest-bearing bond carries interest rate risk, as well as reinvestment risk.

A retired woman whose sole income comes from a portfolio of investments with a fixed rate of return is most affected by A) high inflation B) bearish market conditions C) high income taxes D) volatile interest rates

Portfolios of fixed-income securities are most affected by inflation or rising prices. Rising prices or inflation is known as purchasing power risk. Because the portfolio has a fixed rate of return, interest rate changes will not affect the income received, but that income will have lost some of its purchasing power as a result of rising prices. Tax rates and market conditions would be of lesser importance to this investor.

Credit Risk

Unsystematic risk: -minimized through higher ratings -applies to debt securities, not equity -sometimes referred to as financial risk when too much leverage employed

4 general unsystematic risks

business, liquidity, political, and regulatory

Purchasing power risk

or inflation risk; have limited opportunity for capital appreciation.