Unit 19 Checkpoint Exam

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) regulatory risk. B) market risk. C) business risk. D) financial risk.

B) 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

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) Liquidity B) Credit C) Interest rate D) Market

C) 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 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) liquidity costs. B) marketability costs. C) opportunity cost. D) purchasing power costs.

C) 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.

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) market risk. D) business 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.

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. 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 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.

From first to last, in what order would claimants receive payment in the event of bankruptcy? A) Subordinated debentures, preferred stockholders, general creditors, secured debt B) Preferred stockholders, secured debt, general creditors, subordinated debentures 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.

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) 34% diversified common stocks; 33% long-term convertible debentures; 33% non-cumulative preferred stock 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 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 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) Small-cap stock fund C) Tax-free municipal bond fund D) S&P 500 index fund

D) 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.