Unit 19: Types of Investment Risks

A portfolio that is primarily invested in corporate bonds would be subject to credit risk interest rate risk opportunity cost purchasing power risk A) I, II, III, and IV B) I, II, and IV C) I and II D) II and IV

A) I, II, III, and IV 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.

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) Secured debt, general creditors, subordinated debentures, preferred stockholders C) Secured debt, subordinated debentures, general creditors, preferred stockholders D) Subordinated debentures, preferred stockholders, general creditors, secured debt

B) 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.

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

B) high inflation 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.

Liquidity risk would be greatest for an investor whose portfolio was primarily composed of A) municipal bond UITs. B) municipal bonds. C) Nasdaq stocks. 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 common stock of companies within which industry sector would be most adversely affected by an increase in the general level of interest rates? A) The clothing industry B) The electronics industry C) The utilities industry D) The food industry

C) The utilities industry Utilities are generally very heavily funded with debt. If interest rates go up, their new debt will be at higher interest rates, causing lower earnings available for common stocks.

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) A stock's level of risk is a combination of market risk and diversifiable risk. C) The beta coefficient measures an individual stock's relative volatility to the market. D) Systematic risk may be reduced or eliminated by effective portfolio diversification.

D) Systematic risk may be reduced or eliminated by effective portfolio diversification. It is only unsystematic (diversifiable) risk that may be effectively managed through portfolio diversification. Standard deviation measure a stock's combined systematic (market) and unsystematic (diversifiable) risk. Beta indicates the relative volatility of a stock or portfolio to the market and MPT preaches that higher returns are accompanied by higher levels of risk.

Each of the following would be considered a political risk except A) terrorism. B) nationalization of private industries. C) coups. D) adverse weather conditions.

D) 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.

An investor's portfolio that consists of all long-term Treasury bonds is most vulnerable to which of the following types of risk? A) Marketability risk B) Interest rate risk C) Business risk D) Default (credit) risk

B) Interest rate risk The client is most exposed to interest rate risk because a rise in interest rates would cause a decline in the value of the long-term bonds. This client is also exposed to inflation, or purchasing power risk. There is very little marketability (liquidity) risk and no-default (credit) risk.

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) market risk. D) regulatory 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.

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) Liquidity C) Credit D) Market

A) 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.

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) business risk B) interest rate risk C) market risk D) inflation risk

A) 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).

Which of the following risks would be associated with long-term, AAA-rated bonds? A) Ability of the issuing company to pay interest and principal B) Unstable interest payments C) Purchasing power risk D) Marketability

C) 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 risk that the value of an investment in a limited partnership will decline because of a change in tax law that disallows favored tax treatment for oil exploration costs is called A) interest rate risk B) market risk C) liquidity risk D) legislative risk

D) legislative risk The risk that an investment will decline in value as a result of a change in law is called legislative risk. Regulatory risk is when there is a change to the regulations under which a business must operate

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

D) 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

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) business risk C) legislative risk D) market 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.

Which of the following portfolios would most likely be exposed to the most inflation risk? A) 100% employer's company stock B) 34% diversified common stocks; 33% long-term convertible debentures; 33% non-cumulative preferred stock C) 75% S&P 500 index ETF; 25% municipal bond UIT 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.

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) marketability costs. C) opportunity cost. D) liquidity 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.

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) Mortgage bonds B) First lien, senior preferred stock C) Guaranteed bonds D) Class A common stock

A) 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.

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) Tax-free municipal bond fund C) S&P 500 index fund D) Small-cap stock fund

C) 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.

Individuals are faced with choices every day. Sometimes the choices we make result in a favorable outcome while some choices don't. When it comes to investing, an investor who, when presented with several investment options, selects one that ultimately provides the poorest returns has encountered which risk? A) Liquidity risk B) Business risk C) Market risk D) Opportunity cost

D) Opportunity cost Opportunity cost is the risk that making the wrong choice will provide lower returns. Investors can choose a risk-free investment (91-day T-bill) or some new tech stock promising enormous returns. If that tech stock turns out to be a bust, the investor will have lost the opportunity of a sure-thing (the return on the T-bill). The question doesn't give us enough information about the investment choices to know whether any of these other risks were pertinent.

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) interest expense B) yield curve C) spread 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.

All of the following statements concerning the types of risk are correct except A) financial risk is the risk that a firm's financial structure will negatively affect the value of an equity investment. B) business risk is the uncertainty regarding operating income. C) default risk is the potential inability of a debt issuer to make timely interest and principal repayments. D) reinvestment rate risk is the risk that proceeds available for reinvestment must be reinvested at a higher rate than that of the investment vehicle that generated the proceeds.

D) reinvestment rate risk is the risk that proceeds available for reinvestment must be reinvested at a higher rate than that of the investment vehicle that generated the proceeds. Reinvestment rate risk is the risk that proceeds available for reinvestment might be reinvested at a lower rate than that of the investment vehicle that generated the proceeds. The computation of a bond's yield to maturity assumes that the coupon interest will be reinvested at the coupon rate. Reinvestment risk is the uncertainty of that happening.