Unit 6 - Types of Risk Quiz/Test Questions

Financial risk is most attributed to which of the following investments? A) Corporate bonds B) U.S. government bonds C) Value stock D) Municipal general obligation bonds

A) Corporate bonds Explanation Financial risk is the risk that an issuer would not be able to make principal and interest payments. This rules out government bonds and municipal general obligation bonds because they are backed by taxing power, and stocks don't pay principal and interest.

Which of the following statements regarding systematic risk as it relates to an investment portfolio is true? A) Diversification will not eliminate it. B) Diversification cannot mitigate it to any extent. C) Diversification ensures that portfolios are not subject to it. D) Diversification can be used to eliminate it completely.

A) Diversification will not eliminate it. Explanation Systematic risk is the risk that changes in the overall economy will have an adverse effect on individual securities, regardless of the company's circumstances. Understanding what it is, is to know that no amount of diversification will eliminate it completely. While one might be able to mitigate it somewhat, one cannot diversify away systematic risk.

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

A) a nonsystematic risk. Explanation 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.

Systematic risk would include all of the following except A) business risk. B) interest rate risk. C) inflation risk. D) market risk. Explanation Nonsystematic risks are those associated with the issuer (like a bad business strategy). Systematic risks impact large portions of the market and are difficult to reduce by diversification.

A) business risk. Explanation Nonsystematic risks are those associated with the issuer (like a bad business strategy). Systematic risks impact large portions of the market and are difficult to reduce by diversification.

The risk when investing, where one has the potential to lose all or part of the investment due to circumstances that are unrelated to the issuer's financial strength or well-being, is known as A) capital risk. B) business risk. C) financial risk. D) call risk.

A) capital risk. Explanation This is the definition of capital risk. For example, capital risk might be least when investing in securities backed by the federal government but much more prevalent when investing in derivative products.

Risks that are unique to a specific industry, business type, or investment type are known as A) nonsystematic risks. B) stock market risk. C) security risks. D) systematic risks.

A) nonsystematic risks. Explanation Nonsystematic risks are those that are unique to a specific industry, business enterprise, or investment type.

Inflation risk is most closely associated with A) purchasing power risk. B) nonsystematic risk. C) interest-rate risk. D) call risk.

A) purchasing power risk. Explanation When prices are rising (inflation), purchasing power is reduced. During inflationary periods, a dollar today often doesn't purchase the quantity of goods and services it purchased yesterday.

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) sovereign risk. B) interest-rate risk. C) political risk. D) legislative risk.

A) sovereign risk. Explanation 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.

There are several types of investment risks that will generally fall into two categories. These categories are known as A) systematic and nonsystematic. B) investment and investor. C) averse and nonaverse. D) high return and low return.

A) systematic and nonsystematic. Explanation The two categories of investment risks are systematic (the risk that change in overall economy will impact individual securities) and nonsystematic (those risks that are unique to a particular industry, business, or investment type).

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

B) Bonds Explanation 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.

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) Buy S&P 500 index puts to hedge market risk. Explanation 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.

Which type of securities are most susceptible to business risk? A) Treasury bonds B) Common stock C) Corporate bonds D) Money market instruments

B) Common stock Explanation Treasury bonds are not at all susceptible to business risk; they are backed by the full faith and credit of the U.S. government. Corporate bonds are mostly subject to financial risk, and money markets are very low risk. Common stocks are most at risk from bad business decisions.

Which of the following are considered systematic risks—those that would impact all businesses? I Market risk II Inflation risk III Regulatory risk IV Business risk A) I and IV B) I and II C) II and III D) III and IV Explanation Systematic risk is the risk that changes in the overall economy will impact securities regardless of the company's business. Examples of that are inflation (purchasing power) risk, interest-rate risk, and market risk. Business risk and regulatory risk are examples of nonsystematic risk, the kind of risk that might be unique to certain businesses or industries.

B) I and II Explanation Systematic risk is the risk that changes in the overall economy will impact securities regardless of the company's business. Examples of that are inflation (purchasing power) risk, interest-rate risk, and market risk. Business risk and regulatory risk are examples of nonsystematic risk, the kind of risk that might be unique to certain businesses or industries.

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) I and IV B) I and III C) II and III D) II and IV

B) I and III Explanation This example represents a market risk and a systematic risk.

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

B) It is a nonsystematic risk and, therefore, can be reduced by diversification. Explanation 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. Currency risk is an example of a "borderline" case on its classification as nonsystematic. From the view as a US investor (the default assumption for FINRA exams), currency risk may be mitigated by diversification between domestic and foreign stocks, as well as stocks of companies from different nations. For test purposes it is considered nonsystematic.

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

B) a systematic risk for bonds. Explanation 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.

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) timing risk. D) social risk.

B) business risk. Explanation The failure of the game is an example of business risk. As a business venture the publisher did not do well. Timing and regulation had nothing to do with the failure. Social risk assumes a change in societal attitudes, in this case, there was no change, and the publisher and Thompson just read the market wrong.

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) market risk, which can lead to interest-rate risk. B) call risk, which can lead to reinvestment risk. C) business risk, which can lead to financial risk. D) interest-rate risk, which can lead to financial risk.

B) call risk, which can lead to reinvestment risk. Explanation 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.

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

B) not reduced by diversification within an asset class. Explanation Systematic risk is risk that remains despite diversification. Examples include market risk and interest rate risk.

Those holding the securities of a company where rules might change that impact or upset the way the company does business are exposed to A) financial risk. B) regulatory risk. C) liquidity risk. D) currency risk.

B) regulatory risk. Explanation Changes in the overall regulatory climate or specific rule changes that impact an individual company's business model can have an effect on the company's performance or ability to operate profitably. Those holding the securities of such companies are exposed to regulatory risk.

Purchased 15 years ago with a coupon of 6.25%, a corporate bond in an investor's portfolio has matured. With interest rates now substantially lower at 2.75%, this investor, having no immediate need for the proceeds, is now exposed to A) call risk. B) reinvestment risk. C) financial risk. D) interest-rate risk.

B) reinvestment risk. Explanation The inability to invest proceeds from an investment that had been earning a higher rate of return, at the now current lower rate, is known as reinvestment risk.

Purchased 15 years ago with a coupon of 6.25%, a corporate bond in an investor's portfolio has matured. With interest rates now substantially lower at 2.75%, this investor, having no immediate need for the proceeds, is now exposed to A) call risk. B) reinvestment risk. C) interest-rate risk. D) financial risk.

B) reinvestment risk. Explanation The inability to invest proceeds from an investment that had been earning a higher rate of return, at the now current lower rate, is known as reinvestment 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) sovereign risk. C) political risk. D) interest-rate risk.

B) sovereign risk. Explanation 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.

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

C) 30-year Treasury bond Explanation 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.

Investors face many different risks. Which of the following would be factors of systematic risk? I Decreasing GDP II Global security threats III Call risk IV Net sales A) II and III B) III and IV C) I and II D) II and IV

C) I and II Explanation Systematic risk points to changes in the overall economy. It has an adverse effect on individual securities apart from the company's circumstances. It is generally caused by factors that affect all businesses, such as war, global security threats, or rampant inflation. Call risk is dependent on any call features associated with a given security, and net sales are an issue of a company's success. No matter how diversified a portfolio is, it remains subject to systematic risk. An investor cannot diversify systematic risk away.

Which of the following has the most liquidity risk? A) Stocks listed on NASDAQ B) Listed REITs C) Limited partnerships D) Treasury bonds

C) Limited partnerships Explanation Limited partnerships are generally illiquid; the other options are actively traded securities.

Interest-rate risk A) occurs when interest rates fall, pushing bond prices lower. B) is often called purchasing power risk. C) cannot be reduced by diversification. D) occurs when interest rates rise, pushing bond prices higher.

C) cannot be reduced by diversification. Explanation Interest-rate risk is one of the systematic risks that cannot be reduced by diversification. It is the risk that fluctuating interest rates will impact bond prices. Primarily, when interest rates are rising, bond prices will be pushed lower.

Examples of investments in assets that would be considered illiquid would be all of the following except A) works of art. B) classic automobiles. C) common stock. D) real estate.

C) common stock. Explanation Investments in stocks and bonds are considered fairly liquid, while investments in fixed assets like real estate, art or collectibles are not, and therefore relatively illiquid.

When investing in overseas markets in foreign securities, investors should be aware of and understand A) market risk. B) reinvestment risk. C) currency risk. D) business risk.

C) currency risk. Explanation Whenever investing in securities issued in non-U.S. markets, investors need to be sensitive to the different risks that might apply to foreign investments. Of those listed here, currency risk should be of concern. Currency risk is the possibility that an investment denominated in a foreign currency could decline for U.S. investors if the value of that currency declines in its exchange rate with the U.S. dollar.

Those holding the securities of a company where rules might change that impact or upset the way the company does business are exposed to A) currency risk. B) financial risk. C) regulatory risk. D) liquidity risk.

C) regulatory risk. Explanation Changes in the overall regulatory climate or specific rule changes that impact an individual company's business model can have an effect on the company's performance or ability to operate profitably. Those holding the securities of such companies are exposed to regulatory risk.

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

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

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

D) It can be reduced by diversification. Explanation 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.

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) Market risk B) Price risk C) Equity risk D) Liquidity risk

D) Liquidity risk Explanation 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.

The risk when investing, where one has the potential to lose all or part of the investment due to circumstances that are unrelated to the issuer's financial strength or well-being, is known as A) business risk. B) financial risk. C) call risk. D) capital risk.

D) capital risk. Explanation This is the definition of capital risk. For example, capital risk might be least when investing in securities backed by the federal government but much more prevalent when investing in derivative products.

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

D) diversification. Explanation 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.

Political risk is more associated with A) emerging economies and can never occur in highly developed ones. B) developed economies but could occur even in emerging economies. C) developed economies and not with emerging economies. D) emerging economies, but could occur even in highly developed ones.

D) emerging economies, but could occur even in highly developed ones. Explanation While political risk, the potential instability in the political climate of a country or market, is mostly associated with emerging economies, it must be recognized that it can occur even in highly developed ones as well.

Holding a callable bond with call protection is least impactful for the investor when A) interest rates are stable. B) interest rates are falling. C) interest rates are nonvolatile. D) interest rates are rising.

D) interest rates are rising. Explanation Bonds are more likely to be called when interest rates are falling. Call protection, a length of time during which the bond cannot be called, protects the investor during these times. Therefore, the call protection is least impactful when interest rates are rising—in other words, least impactful during times when the bond wouldn't likely be called.

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) business risk. B) political risk. C) regulatory risk. D) legislative risk.

D) legislative risk. Explanation 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) sales risk. B) market risk. C) systematic risk. D) nonsystematic risk.

D) nonsystematic risk. Explanation This is an issue that applies to just this issuer; a nonsystematic risk.