S66 Unit 19 (Types of investment risk) Quiz
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 utilities industry C) The food industry D) The electronics industry
B) The utilities industry Explanation 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. LO 19.a
You have a 45-year-old client wishing to save for retirement. The client does not have a great deal of investment sophistication and inquires about the risks you have exposed him to by placing the majority of his portfolio in listed common stocks. You would respond that one risk that should not be a concern to this investor is A) business risk. B) liquidity risk. C) inflation risk. D) systematic risk.
B) liquidity risk. Explanation A portfolio of listed common stocks will have little to no liquidity risk because listed shares are easily traded. Even though common stock tends to offer protection against inflation, there is no assurance that the portfolio will keep pace with the rising cost of living. Historically, common stock has offered protection against inflation. There are no guarantees, but a portfolio consisting largely of common stock is the most likely to keep pace with the rising cost of living. A portfolio largely consisting of common stock is going to be subject to market risk, the most frequently used example of systematic risk. LO 19.b
Credit risk is commonly referred to as A) business risk B) unsystematic risk C) default risk D) interest rate risk
C) default risk Explanation Credit risk, also known as default risk, is the risk that a company may have financial issues that lead to default on its debt obligations, bankruptcy, or both. LO 19.b
If a business fails because a new technology makes its products obsolete, this is an example of A) systematic risk B) interest rate risk C) unsystematic risk D) inflation risk
C) unsystematic risk Explanation Unsystematic (business) risk is the danger inherent in conducting the operations of the business itself. Technology companies are especially sensitive to business risk as a result of competing technologies. Systematic (market risk) refers to risk of the overall market. Inflation risk refers to the loss of buying power as the result of the increase in prices. Interest rate risk is the danger that interest rates will increase, causing a fixed-income security to decline in price. LO 19.b
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) Systematic risk B) Market risk C) Credit risk D) Unsystematic risk
D) Unsystematic risk Explanation Unsystematic risk (diversifiable risk) is the risk that is eliminated when the investor builds a well-diversified portfolio. Credit risk is a form of unsystematic risk. LO 19.b
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 sure to recover 100% of your investment C) are paid ahead of everyone, except past-due wages to employees D) are paid ahead of holders of unsecured debt, as well as equity securities
D) are paid ahead of holders of unsecured debt, as well as equity securities Explanation Secured bondholders are on the top of the list of creditors. The first priority for unsecured claims is that of employees and taxes. Even with a secured claim, there is no assurance that you will receive all your money back (think of the "short sales" on homes not long ago where the bank accepted less than the mortgage amount because the value of the home had fallen so far). LO 19.d
Which of the following is the risk that diminishes through portfolio diversification? A) Unsystematic risk B) Purchasing power risk C) Systematic risk D) Interest rate risk
A) Unsystematic risk Explanation Unsystematic risk (diversifiable risk) is the risk that is eliminated when the investor builds a well-diversified portfolio. Interest rate risk and purchasing power risk are examples of systematic (nondiversifiable risk). LO 19.b
A retired woman whose sole income comes from a portfolio of investments with a fixed rate of return is most affected by A) high inflation B) bearish market conditions C) volatile interest rates D) high income taxes
A) high inflation Explanation 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. LO 19.a
Angela, a wealthy client of yours, has constructed her portfolio with individual common stocks that closely match the weighting of the S&P 500 index. In so doing, Angela has significantly reduced her A) market risk B) systematic risk C) default risk D) business risk
D) business risk Explanation By matching the composition of the S&P 500 index, the client has broadly diversified her portfolio. One of the primary benefits of diversification is the reduction of business risk, an unsystematic risk. Market risk, one of the systematic risks, is not reduced through diversification. Default (or credit) risk, would apply when the portfolio contains debt securities. LO 19.b
All of the following are examples of non-diversifiable risks except A) market risk B) purchasing power risk C) interest rate risk D) liquidity risk
D) liquidity risk Explanation Liquidity risk is a type of unsystematic, or diversifiable, risk. All of the other choices are systematic risk, which is considered to be non-diversifiable. LO 19.b
The major risk for highly rated corporate bonds is A) interest rate changes B) tax law changes C) stock market volatility D) liquidity
A) interest rate changes Explanation Because rising interest rates cause the prices of all bonds to decline, interest rate changes are the major risk factor for bonds. The bond market sometimes moves in the opposite direction to the stock market (negative correlation). LO 19.a
Because of the decline in sales revenues, a company that had forecast an earnings growth of 25% now forecasts growth of only 12%. This is an example of what type of risk in the investment of securities? A) Business risk B) Purchasing power risk C) Market risk D) Interest rate risk
A) Business risk Explanation In this question, we have a company that did not perform as it had anticipated, which represents the business risk of investing in this particular security. The fact that their earnings growth was only half their original projections had nothing to do with the market. Interest rate risk applies to the uncertainty that the market price of a security might change solely due to the changes in the cost of money. Purchasing-power risk is the uncertainty that a dollar will represent less buying power in the future. LO 19.b
The debt obligations of a company that has issued securities to fund its expansion are considered an example of what type of investment risk? A) Credit or default risk B) Reinvestment rate risk C) Market risk D) Purchasing power risk
A) Credit or default risk Explanation A company using borrowed capital to expand is increasing its financial leverage. As such, the possibility of default increases. Investors can reduce their risk either by diversifying into companies using minimal leverage or selecting those issuers with higher credit ratings. The other risks noted are systematic or nondiversifiable risk. LO 19.b
The risk known as opportunity cost is often measured by A) comparing the investor's actual return to the return on the 91-day Treasury bill. B) the tax-equivalent yield. C) whether the investment had positive or negative returns. D) comparing the yield to maturity to the nominal yield.
A) comparing the investor's actual return to the return on the 91-day Treasury bill. Explanation In economic terms, opportunity cost is defined as the highest valued alternative that must be sacrificed as a result of choosing among alternatives. It is common to use the 91-day T-bill as the risk-free alternative. If the selected investment does not outperform the risk-free one, the investor has lost out on the guaranteed return. LO 19.c
If interest rates are dropping, an investor with a maturing bond will be most concerned with A) the difficulty in finding another investment with a like yield B) a positive yield curve C) a negative yield curve D) the quality declining with the yield
A) the difficulty in finding another investment with a like yield Explanation When interest rates decline, investors with maturing bonds will have to accept a lower return on their reinvested principal. This is often called reinvestment risk. Although zero-coupon bonds avoid this risk until maturity, once the bond matures, just like any other bond, the matured principal will have to be invested at current market yields. LO 19.a
Which of the following are considered unsystematic risks? I) Business II) Liquidity III) Market IV) Purchasing power A) III and IV B) I and III C) I and II D) II and IV
C) I and II Explanation There are 4 general unsystematic risks: business, liquidity, political, and regulatory. Market and purchasing power risk are systematic. LO 19.b
Which of the following describes unsystematic risk? A) It is related to market forces and can be diversified away. B) It is specific to an investment and cannot be diversified away. C) It is specific to an investment and can be diversified away. D) It is related to market forces and cannot be diversified away.
C) It is specific to an investment and can be diversified away. Explanation It is critical to remember that unsystematic risk is diversifiable. That narrows the choices to 2. Then, we know that it is systematic risk that deals with the overall market, so that cuts it down to 1 possible choice. LO 19.b
Which of these is not considered to be a systematic risk? A) Exchange rate risk B) Default risk C) Purchasing power risk D) Market risk
B) Default risk Explanation Recall the P.R.I.M.E. acronym for systematic (or nondiversifiable) risk: Purchasing power, Reinvestment, Interest rate, Market, and Exchange rate risks. Default or credit risk is a form of unsystematic (or diversifiable) risk. LO 19.a
One of the risks found in equity investing is known as unsystematic risk. The most common way to reduce this risk is? A) Reducing the beta coefficient B) Diversification C) Specialization D) Increasing the positive correlation
B) Diversification Explanation Unlike systematic (market) risk, unsystematic or nonsystematic risk can be reduced through diversification. It's the old "don't put all of your eggs in one basket" concept. LO 19.b
Which of the following statements regarding risk diversification is least accurate? A) Systematic risk or market risk results from unexpected changes in economic factors. B) There is a tradeoff between risk and return. C) Diversification can successfully remove all portfolio risk. D) Unsystematic risk is company-specific risk that is particular to an individual company.
C) Diversification can successfully remove all portfolio risk. Explanation Diversification cannot remove all the risk. There are certain things, such as economic news, that tend to impact the whole market. The risk that can be removed is known as the specific or unsystematic risk, and the risk that cannot be diversified away is market or systematic risk. LO 19.b
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 Explanation 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. LO 19.b
Which of the following is an example of business risk? A) A company's earnings decline because of a change in technology. B) The value of the U.S. dollar declines, making imports more expensive. C) The Dow Jones Industrial Average falls sharply. D) Inflation increases at a greater rate than expected.
A) A company's earnings decline because of a change in technology. Explanation Business risk, also called unsystematic risk, is company-specific risk: the risk that an event will affect a particular company rather than the market as a whole. LO 19.b
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) market risk B) regulatory risk C) financial risk D) opportunity cost
A) market risk Explanation Market risk is the uncertainty that a stock's price will move in a manner unrelated to the company's fundamentals. A prime example of this is when earnings go one way and the stock price goes the other. What we are not told in the question is the performance of the stock market. It is likely that the overall market has declined over this period. Financial risk is, as the name indicates, related to financing circumstances. The most common financial risk is when excess leverage has been employed. Another financial risk is lack of cash flow, but nothing in this question indicates that situation. LO 19.a
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) Marketability C) Purchasing power risk D) Unstable interest payments
C) Purchasing power risk Explanation 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. LO 19.a
