SIE Unit 6

An investor chooses to have a portfolio made up of domestically listed U.S. securities only. In so doing, this investor is primarily avoiding which of the following two risks? A) Political and currency B) Market and purchasing power C) Inflation and interest rate D) Call and reinvestment

A

Which types of investments are most susceptible to interest rate risks? A) Bonds B) Common stocks C) Money market instruments D) Options

A, Bond prices move down when interest rates move up. Money market instruments can also be affected, but bonds are more impacted due to longer duration

An investor holding a 4.5% callable bond has it called away by the issuer when interest rates fall to 3.5%. This is an example of A) call risk, which can lead to reinvestment risk. B) business risk, which can lead to financial risk. C) interest-rate risk, which can lead to financial risk. D) market risk, which can lead to interest-rate risk.

A, Call risk (the risk that when interest rates fall, issuers will call in existing callable debt) issues often leads to reinvestment risk for the investor. While receiving one's principal back sooner than expected, the investor is now left to reinvest at the now lower yield rates.

An investor holds shares of a manufacturing company where disposal of the by-products produced during the manufacturing process is necessary. The Environmental Protection Agency (EPA) updates the rules applicable to disposing of the product. For the investor, these changes present a form of A) regulatory risk. B) liquidity risk. C) financial risk. D) political risk.

A, Changes in the regulatory climate or specific rules that might impact how a company operates or its ability to do so profitably are recognized as regulatory risk.

By virtue of a stocks listing for trading on a U.S. stock exchange, which of the following risks is reduced or even recognized as eliminated? A) Liquidity risk B) Price risk C) Market risk D) Equity risk

A, One of the advantages of a security being traded on a U.S. listed stock exchange is the ready availability of buyers and sellers. This means the investment can be considered a liquid one—easy to divest of at a fair price, if and when one needs to.

Regarding different types of risk, which of the following is true? A) Enactment of, or changes in laws, represent potential legislative risk. B) Changes in regulations represent potential legislative risk. C) Changes in regulations represent political risk. D) Enactment of, or changes in, laws represent political risk.

A, The enactment of, or changes in, laws represent potential legislative risk, whereas enactment of, or changes in, regulations represent regulatory risk. Political risk is specific to potential political instability associated more with emerging economies.

The Federal Reserve Bank is raising interest rates, this will A) push bond prices lower in the open market. B) push bond prices higher in the open market. C) make bonds trading in the open market more desirable. D) have no impact on bond prices in the open market.

A, This is interest-rate risk. When interest rates are rising, bond prices in the open market are pushed down. Rate movements and prices have an inverse relationship. Those already holding the bonds in their portfolios see their investments decrease in value. This also makes bonds trading in the open market less desirable because new issue bonds will be yielding the now higher rates and comparably be more desirable.

An investor has a bond maturing during a time when interest rates are falling. It is likely that the investor, wanting to keep the funds invested, would be most concerned with A) reinvestment risk. B) inflation risk. C) purchasing power risk. D) business risk.

A, When interest rates are declining, it is difficult to invest proceeds from redemptions or distributions and maintain the same level of income one had previously without increasing credit or market risks. This is reinvestment risk.

Five years ago Thompson, an investor, ran across a board game that he enjoyed and believed the game would become very popular. He purchased 1,000 shares of the corporation that publishes the game. Unfortunately, the game was too complex for most casual game players and sales never amounted to much. Over the five years, the stock of the publisher has remained steady, but has not increased in value. This is an example of A) regulatory risk. B) business risk. C) social risk. D) timing risk.

B

Which of the following would be most susceptible to currency risk? A) Municipal bonds B) Common stock of a large, well established company in England C) Common stock of a small cap company in the United States D) Treasury bonds

B, Currency risk is due to the variations in exchange rate between countries and only impacts international investing.

A strategy that blends various types of investment in an effort to reduce nonsystematic risk is called A) dollar cost averaging. B) diversification. C) sector rotation. D) capital preservation.

B, Nonsystematic risk occurs based on circumstances or events that are unique to a specific security. This risk can be managed by diversifying the assets in a portfolio by selecting securities that possess different risk and/or return characteristics.

Which of the following investments would be most susceptible to inflation risk? A) Growth stock B) 30-year Treasury bond C) 10-year corporate bond rated BBB D) Value stock

B, Stocks generally have had performance that outpaces inflation. Lower quality bonds with shorter maturities would pay a higher rate than government bonds and have the potential to keep up with inflation. Treasuries have very low yields and do not keep pace with inflation.

Your customer, Ivan, owns a diversified portfolio of large cap stocks. He would like to find a way to hedge the market risk in his portfolio. Which of these actions might you recommend to accomplish his goal? A) Sell all his stocks and wait for a better time. B) Buy S&P 500 index puts to hedge market risk. C) Diversify his portfolio further. D) Tell him to do nothing because there is no way to mitigate systematic risk.

B, Your customer is worried about market risk, a systematic risk. Further diversifying his portfolio will not help. Selling everything is likely not helping, and means he may miss any upward moves while he is waiting it out. Derivatives like options (index puts in this case) may be used to offset market risk. LO 6.e

A risk that is specific to a particular issue or issuer is A) impacts a broad group of securities equally. B) cannot be reduced by diversification. C) a nonsystematic risk. D) is a systematic risk.

C, A risk that is specific to a particular issue or issuer is part of the definition of nonsystematic risk. It may be mitigated by diversification.

A company is about to introduce a new product. While confident in the product's appeal and market, it is still an unknown factor until sales results are viewed later. Investors holding stock in the company are at this time specifically exposed to A) reinvestment risk. B) call risk. C) business risk. D) financial risk.

C, Business risk is an operating risk related to poor or untimely management decisions. Decisions regarding if and when to introduce new products are one example of those that might expose investors specifically to business risk.

Which of the following accurately characterizes capital risk? A) It is minimal when investing in derivatives, such as options. B) It is the potential for loss due to an issuer's financial strength. C) It can be reduced by diversification. D) It is always high when investing in government securities.

C, Capital risk is one of the nonsystematic risks that can be reduced by diversification. It represents the potential for loss due to circumstances unrelated to an issuer's financial strength. While it is considered minimal to none for U.S. government securities, it is generally high for derivative products, such as options.

The effect of continually rising retail prices on the investment returns of one's portfolio is best described as A) call risk. B) reinvestment risk. C) inflation risk. D) business risk.

C, Inflation, or continually rising prices, reduces the purchasing power that one's investment returns will have. This is the essence of inflation risk.

For investors, changes made to the tax code by the IRS are known as a form of A) political risk. B) financial risk. C) legislative risk. D) regulatory risk.

C, Legislative risk results from changes in the law, not regulations. Changes in tax laws are one example.

Risk that prevails despite diversification within an asset class is A) business risk. B) unsystematic risk. C) systematic risk. D) call risk.

C, Risk that prevails despite diversification is one of the defining characteristics of systematic risk.

New Haven Farms is a producer of specialty foods. They recently received a notice that the Wetlands Maintenance and Drainages Act (The WMD Act) passed indicates that a significant portion of their current land used in food production falls under the act's protection and may no longer be used for agriculture. This is an example of A) regulatory risk. B) business risk. C) legislative risk. D) political risk.

C, The best answer is legislative risk, as this was caused by a change in the law. Regulatory risk is a change in the application of existing rules, while political risk is normally associated with a change in leadership. Business risk would be a bad business plan, not a working business plan damaged by changing laws.

The risk that a stock will not appreciate in value due to poor cash flow is an example of A) systematic risk. B) market risk. C) nonsystematic risk. D) sales risk.

C, This is an issue that applies to just this issuer; a nonsystematic risk.

Kamron owns a diversified portfolio of stocks. The portfolio holds 58 different stocks that are diversified by market capitalization and sector as well as industry. When the stock market entered a significant downward correction Kamron's portfolio also dropped. This is an example of which of these? I Market risk II Business risk III Systematic risk IV Unsystematic risk A) II and III B) I and IV C) II and IV D) I and III

D

Which of the following is true regarding currency risk? A) It is a nonsystematic risk and, therefore, cannot be reduced by diversification. B) It is a systematic risk and, therefore, can be reduced by diversification. C) It is a systematic risk and, therefore, cannot be reduced by diversification. D) It is a nonsystematic risk and, therefore, can be reduced by diversification.

D, Currency risk is the possibility that an investment denominated in one currency could decline if the value of that currency declines in its exchange rate with the U.S. dollar. This is one of the severable nonsystematic risks that can be mitigated by utilizing diversification.

The risk that all or a significant portion of the sum invested might be lost is known as A) call risk. B) market risk. C) purchasing power risk. D) capital risk.

D, Particularly when taking aggressive positions, such as in options or DPPs, there is a greater likelihood that a substantial portion of the initial investment can be lost. This is best described as capital risk.

Systematic risk is A) associated with debt instruments. B) may be significantly reduced by diversification within an asset class. C) associated with equity investments. D) not reduced by diversification within an asset class.

D, Systematic risk is risk that remains despite diversification. Examples include market risk and interest rate risk.

The inverse relationship between interest rates and bond prices helps in understanding that interest rate fluctuations are A) an unsystematic risk for bonds. B) the difference between credit and financial risk. C) an example of regulatory risk. D) a systematic risk for bonds.

D, The inverse relationship illustrates a significant systematic risk for bonds and other fixed-income investments. When rates move up all bonds move down. Credit and financial risk are largely synonymous terms. Interest rate risk is not a regulatory risk.

The ratings on the debt instruments of a foreign country with outstanding loans from a number of other countries worldwide have been downgraded. The impact felt due to the risk of possible default is known as A) legislative risk. B) interest-rate risk. C) political risk. D) sovereign risk.

D, While it can be noted that sovereign risk is a type of political risk, the risk of default by a country on its debt instruments is specifically recognized as sovereign risk.

SYSTEMATIC RISKS:

MARKET RISK, INTEREST RATE RISK, REINVESTMENT RISK, INFLATION RISK (PURCHASING POWER RISK)