Unit 11 - Types of Investment Risks

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 a given amount invested today in a fixed income instrument will not generate the same nominal income in the future C) The uncertainty that the nominal return of an investment will not outpace the overall market D) The uncertainty that one will not receive back an equal amount of principal in the future

A) The uncertainty that the value of an investor's assets will decrease as measured by real dollar purchasing power

One of your firm's portfolio managers is discussing risk that can be reduced during the portfolio construction process. Which of the following options might she be referring to? A) Unsystematic risk B) Market risk C) Systematic risk D) Credit risk

A) Unsystematic risk

The risk to bondholders that bonds may lose value during periods of increasing inflation is known as A) interest rate risk B) reinvestment risk C) credit risk D) marketability risk

A) interest rate risk Interest rate risk is the risk that as interest rates rise, bond prices fall. Periods of inflation are accompanied by rising interest rates. Another risk in this scenario, but not an answer choice, is purchasing power risk; each semiannual interest payment has less purchasing power due to inflation, and, of course, the purchasing power of the principal at maturity will be far less as well.

An agent for a well-known broker-dealer has taken it upon herself to look for investment opportunities for her clients. Her research indicates that, in spite of record earnings, the stock of GEMCO, Inc., is poised for a price reversal. Should this analysis prove correct, this would be an example of A) market risk B) regulatory risk C) reinvestment risk D) financial risk

A) market risk Market risk is the uncertainty that the market price of a stock will drop even when earnings are strong. Most stocks follow the "market" and this would appear to be no exception. Financial risk concerns itself with financing, particularly debt, so it is related to credit risk. Nothing in this question infers anything about financing difficulties.

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) systematic risk. B) financial risk. C) political risk. D) business risk.

A) systematic risk.

Among the advantages of being the holder of secured bond is that if the issuer files for bankruptcy, you A) will receive your principal plus all unpaid interest B) are paid ahead of holders of unsecured debt, as well as equity securities C) are sure to recover 100% of your investment D) are paid ahead of everyone, except past-due wages to employees

B) are paid ahead of holders of unsecured debt, as well as equity securities

Which of the following statements regarding unsystematic risk are TRUE? I. It is the risk that an individual stock will not perform well. II. It is the same as market risk. III. Diversification reduces it. IV. Diversification does not reduce it. A) II and III B) II and IV C) I and III D) I and IV

C) I and III

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

C) 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.

Which of the following would constitute political risk that might affect a security? A) A bad decision by the company's CEO B) New environment regulations C) New tariffs are levied against the company's major product D) A strike by the union representing the company's employees

C) New tariffs are levied against the company's major product ​Political risk involves political activities, and of the choices given, the only one that is the result of actions by a political body is the decision to raise tariffs. A strike has nothing to do with politics (theoretically), and environmental regulations create regulatory risk.

Which of the following industries is most exposed to regulatory risk? A) Publishing companies B) Entertainment companies C) Public utilities D) Consumer retailers

C) Public utilities

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

C) adverse weather conditions.

Credit risk is commonly referred to as A) business risk B) interest rate risk C) default risk D) unsystematic risk

C) default 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) business risk C) legislative risk D) credit risk

C) legislative risk

Prior to the opening of the securities markets, KAPCO Chemical Corporation reports quarterly earnings per share of $1.50, exceeding analysts' estimates by more than 10%. By the end of the trading session, KAPCO's stock price has fallen by 5%. This would be an example of A) financial risk B) regulatory risk C) market risk D) opportunity cost

C) market risk

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) Systematic risk B) Business risk C) Reinvestment rate risk D) Default risk

D) 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.

Which of the following describes unsystematic risk? A) It is specific to an investment and cannot be diversified away. B) It is related to market forces and cannot be diversified away. C) It is related to market forces and can be diversified away. D) It is specific to an investment and can be diversified away.

D) It is specific to an investment and can be diversified away.

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 food industry B) The electronics industry C) The clothing industry D) The utilities industry

D) The utilities industry

Your client purchases 100 shares of XYZ Electric Auto Company on the assumption that rising fuel costs will create more interest in this more efficient means of transportation. If he is wrong, the resulting drop in the market price of that stock would be due to A) purchasing power risk B) money-rate risk C) market risk D) business risk

D) business risk This question refers to a client who is investing in the success of a specific company. The failure of this company does not mean that all securities will be affected; therefore, he is not subjected to market risk. The failure of XYZ would be due to the fundamentals of the company itself and considered business risk.

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

D) default risk.

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) spread C) yield curve D) opportunity cost

D) opportunity cost