SIE Chapter 20-- Investment Risks

Hedging: Currency Options

- allow investors to take a position based on the value of a foreign currency as it compares to the U.S. dollar - investors take option positions on a foreign currency with the U.S. dollar on the other side of the contract -- gain or loss is based on the inverse relationship between value of the foreign currency and the value of the U.S. dollar

Hedging: Index Options

- calls/puts on an index can make it easier to hedge an entire portfolio

Hedging: Equity Options

- hedge long positions with puts - hedge short positions with calls

Systematic (Non-Diversifiable) Risk: Inflation Risk

- primarily affects existing bondholders due to causing i rates to rise - best protection comes from: -- variable annuities -- real estate -- precious metals -- stocks

Systematic (Non-Diversifiable) Risk: Interest Rate Risk

- primarily affects existing bondholders, since the market value of their investments will decline if interest rates rise - diversified bond portfolios are still subject to the interest rate risk - longer maturitied bonds are more subject to interest rate risk - rising interest rates hurts utility stocks and other stocks of corps that are heavy borrowers

Crunch Time Fact #3

A Ginnie Mae security is impacted by all of the following risks - prepayment risk, reinvestment risk, and fluctuations in the principal value of underlying mortgages.

Which of the following bonds has the most interest-rate risk? A) A bond maturing in five years B) A bond maturing in 20 years C) A bond maturing in 10 years D) A bond maturing in 15 years

B) A bond maturing in 20 years The bond with the most interest-rate risk or price volatility is the one with the longest maturity and lowest coupon. As a result the bond maturing in 20 years will have the greatest interest-rate risk.

Which investment has the most inflation risk? A)Stocks B) Bonds C) ETFs D) ADRs

B) Bonds Inflation risk is the risk that prices of goods and services will rise faster than an investor's savings. Since bonds typically have a fixed interest-rate (i.e., rate of return), they are more susceptible to inflation than stocks, ETFs, and ADRs.

A company has been struggling and has failed to make the most recent interest payment on the bonds that it has issued. This issuer's bondholders have experienced: A) Capital risk B) Liquidity risk C) Credit risk D) Reinvestment risk

C) Credit risk These bondholders have experienced credit risk of the issuer. Credit risk, also referred to as default risk, is the risk that a bond issuer will not make interest and/or principal payments on its bonds. Capital risk is the risk of losing all or a part of your investment. Reinvestment risk is the result of not being able to reinvest at the same rate after a bond matures or is called. Liquidity risk is realized when an investment cannot be disposed of quickly and at a price that's related to recent transactions.

Crunch Time Fact #4

If an investor wants a hedge against inflation, common stock is an appropriate investment.

Crunch Time Fact #5

If an investor wants to preserve capital, an appropriate investment is short-term U.S. government bonds.

Crunch Time Fact #1

Interest-rate risk (most for long-term bonds) and inflation risk (most for bonds in general) are forms of systematic risk.

Crunch Time Fact #2

Political risk is a form of unsystematic risk.

Buy and Hold Strategy

Pros: - transaction costs and tax consequences are minimized since there's no selling or purchasing of assets - potential for retention of appreciating assets Cons: - as the asset mix of the portfolio drifts, its risk/reward characteristics are altered (high volatility may scare investor)

Regulatory Risk & Legislative Risk

Regulatory-- regulatory changes may have a negative impact on an investment's value Legislative-- new laws may have a negative impact on an investment's value

Systematic (Non-Diversifiable) Risk: Market Risk

- day-to-day potential for an investor to experience losses due to market fluctuations in securities' prices - beta => above 1 = more volatility than market, below 1 = less volatility than market -- amount of non-diversifiable risk associated with a particular portfolio or asset

Indexing

- either maintaining investments in companies that are part of major stock (or bond) indexes or investing in index funds directly - done based on the idea that its f*** hard to beat the market

Liquidity Risk

- illiquid assets are more risky - hedge funds, private placements, direct participation programs (limited partnerships), and real estate suffer from this risk

Capital Risk

- investor could lose all or a portion of her investment - common with options investors -- if the options purchased expire worthless, the investor will lose 100% of their capital

Reinvestment Risk

- investor may not be able to reinvest her principal at the same interest rate after a bond matures or is called - investor's choices: 1) accept lower rate of return 2) assume a higher degree of risk to keep returns stable

Call Risk

- issuer may decide to pay back its bondholders prior to maturity

Alpha

- measures the risk that's specific to a particular company Alpha = stock's real return - expected return

Sector Rotation Strategy (Active Strategy)

- moving money from one industry or sector to another in an attempt to beat the market - manager tries to time the next turn in the business cycle and shift assets to the sectors that will derive the most benefit - utilities do well while airlines perform poorly during the beginning of a recession

Currency/Exchange Rate Risk

- possibility that foreign investments will be worth less in the future due to changes in exchange rates -

Opp Cost Risk

- possibility that the return of a selected investment is lower than another investment that was not chosen

Portfolio Rebalancing

- process of buying and selling assets on a periodic basis (may be either fixed schedule or as needed) Frequent rebalancing: - pro-- keeps client's portfolio closer to its strategic allocation - con-- more transaction costs

Credit Risk

- risk that a bond issuer will not make payments as promised

Business Risk

- risk that certain circumstances or factors may have a negative impact on the operation or profitability of a specific company. - think competition and demand risk

Political Risk

- risk that foreign investors will lose money due to changes that occur in a country's government or regulatory environment - war, military coups, terrorism

Dollar Cost Averaging

- systematic approach in which a person invests a fixed-dollar amount at regular intervals, regardless of the market price of the security - makes no attempt to time the market & accepts that the market is subject to erratic swings

Prepayment Risk

- unique to mortgage-backed securities - homeowners may pay off their mortgages early due to refinancing as a result of lowered interest rates -- passthrough investors will then need to reinvest this large amount of principal at a time when interest rates have declined (making it harder to get same ROI)

Which of the following situations is an example of reinvestment risk? A) After interest rates decreased, issuers called their bonds back and issued new bonds with lower interest rates. For bond investors to realize the same return on new bonds, they are forced to purchase lower quality bonds. B) An individual purchased a security that ultimately yielded significantly less than another that he could've chosen. C) A bond issuer is having financial difficulties and is unable to make interest and principal payments on its debt. D) The payments on mortgage-backed securities are ending early due to homeowners refinancing the mortgages as interest rates fall.

A) After interest rates decreased, issuers called their bonds back and issued new bonds with lower interest rates. For bond investors to realize the same return on new bonds, they are forced to purchase lower quality bonds. Reinvestment risk is the result of not being able to reinvest at the same rate after a bond matures or is called. Opportunity risk is the risk that a chosen investment will yield less than another investment that was not chosen. When interest fall, mortgages may be refinanced and paid off early, which results in prepayment risk on mortgage-backed securities. Credit risk occurs when a bond issuer is unable to make payments of interest and principal.

A client sells the shares she owned of a company whose stock is a part of a major market index. If the proceeds are reinvested in an S&P 500 Index fund, the client has reduced which of the following risks? A) Business B) Market C) Economic D) Political

A) Business By selling the individually owned shares, the client is no longer subject to the risks that may affect that single company. Investing the proceeds in the S&P 500 Index fund will provide the client with greater diversification.

Which of the following risks affects bonds primarily when interest rates decline? A) Call risk B) Credit risk C) Political risk D) Currency risk

A) Call risk When interest rates decline, bond issuers are more likely to call in existing, higher interest rate bonds and replace them by issuing bonds paying lower rates. Investors whose bonds are called are then faced with reinvesting their principal at lower rates.

A U.S. company receives a significant amount of its revenue from international sales. This revenue is received in the currencies of various countries, exposing the company to: A) Currency risk B) Capital risk C) Opportunity risk D) Reinvestment risk

A) Currency risk Currency risk occurs when the value of foreign currencies change in relation to the value of the U.S. dollar. Falling foreign currency values or rising U.S. dollar values result in a strong dollar. If this happens, the return on foreign investments will fall since the foreign currencies will purchase fewer U.S. dollars on conversion.

Investors in mortgage-backed securities are MOST concerned with prepayment risk if interest rates are: A) Falling B) Rising C) Stable D) Fluctuating

A) Falling If interest rates are falling, homeowners are more likely to refinance their mortgages, which results in the prepayment of these existing mortgages. For investors in mortgage-backed securities, they would be forced to find alternative investments that are likely paying lower rates of interest.

Which of the following types of risk would have the greatest impact on a 20-year corporate bond during the first year of the investment? A) Interest-rate risk B) Liquidity risk C) Market risk D) Inflation risk

A) Interest-rate risk A change in interest rates would most likely have the greatest impact on the bond in the first year of the investment. If interest rates were to go up or down, that could dramatically change the bond's price. The risk presented by inflation would be significant over a longer term. Liquidity risk is the risk that a security cannot be traded quickly enough in the market to prevent a loss (or make the required profit). Market (systematic) risk is the risk that a security's value may decline over a given period due to economic changes or other events that impact large portions of the market.

Which types of investments have historically shown a great deal of sensitivity to regulatory risk? A) Limited partnerships B) Corporate bonds C) Common stocks D) Variable annuities

A) Limited partnerships Regulatory risk is the possibility that changes in regulations can have an adverse impact on the value of investments. This is very similar to legislative risk, which is the risk associated with changes in laws. Although all kinds of investments can be subject to regulatory and legislative risk, limited partnerships have historically been particularly vulnerable. For example, adverse changes in the tax laws can cause the value of many limited partnerships to decline.

Which of the following is NOT a type of systematic risk? A) Liquidity risk B) Market risk C) Interest-rate risk D) Inflation risk

A) Liquidity risk Liquidity risk is an example of unsystematic or diversifiable risk, which is applicable to a specific security. On the other hand, systematic risk is one that affects all asset classes in the same manner. Examples of systematic risk include market risk, interest-rate risk, and inflation risk. If there is an overall decline in the stock market, it will cause stock prices to go down (market risk). If market interest rates rise, it will cause bond prices to decline (interest-rate risk). And finally, an increase in the rate of inflation will generally cause the overall bond market to decline.

An investor has a portfolio in which 25% is invested in an oil company, 35% is invested in a pharmaceutical stock, 30% is invested in an exchange-traded fund that tracks the S&P 500 Index, and the final 10% is invested in money-market funds. Which of the following risks is inherent in the portfolio? A) Non-systematic B) Political C) Credit D) Liquidity

A) Non-systematic Non-systematic risk is specific to one company and can be diversified away by diversifying a portfolio. Since the investor has put 60% of her portfolio into only two stocks, she's not diversified and is exposed to a large amount of non-systematic risk. Credit risk is typically associated with bonds and is the risk that an issuer cannot repay its interest and/or principal. Liquidity risk is the inability to sell an asset easily, which is not a concern in this portfolio since exchange-traded stocks are typically liquid. Political risk is associated with politicians making decisions that will impact an investment.

An investor shifted the allocation of corporate bonds in his portfolio to American Depository Receipts (ADRs). As a result, he will be more exposed to: A) Political risk B) Liquidity risk C) Credit risk D) Interest-rate risk

A) Political risk ADRs are depository receipts for foreign equities. Although ADRs trade in the U.S., they are subject to the risks of investing in foreign securities. Political risk is the risk that foreign investors will lose money as a result of changes in a specific country's government or regulatory environment. Many investments are subject to liquidity risk. Credit and interest-rate risk are usually associated with bond investments.

Which of the following investments has the MOST capital risk? A) Technology stock B) T-notes C) TIPS D) REITs

A) Technology stock Capital risk is the risk of losing an entire investment and is higher for common stock, especially stock in a technology company.

Buy-and-hold and systematic rebalancing are examples of passive approaches to asset allocation. Both of these methods are based on: A) The Efficient Market Hypothesis B) The Sector Rotation Theory C) The Indexing Theory D) The Dollar-Cost Averaging Theory

A) The Efficient Market Hypothesis The Efficient Market Hypothesis (Theory) states that financial markets are efficient and that the prices of securities reflect all known information; therefore, it is impossible to outperform or time the market. Both buy-and-hold and systematic rebalancing approaches are based on the Efficient Market Hypothesis. Sector rotation is the moving of investments from one industry sector into another in anticipation of a change in the economy. Indexing involves purchasing securities that are a part of a major index or purchasing and index fund. Dollar-cost averaging is a method of investing that focuses on making consistent dollar investments regardless of share prices.

Which investment is most subject to inflation risk? A) Treasury bonds B) Treasury bills C) Utility stocks D) Blue chip industrial stocks

A) Treasury bonds Inflationary risk is associated with prices rising and investors not being able to buy as many goods and services as expected (i.e., loss of purchasing power). Fixed income investments (i.e., bonds) and fixed annuities typically have the most inflation risk. When choosing between two bonds with different maturities, long-term bonds (e.g., T-bonds) have more inflation risk than short-term bonds (e.g., T-bills).

How can a client minimize principal risk in bonds due to fluctuating interest rates? A) Buy long-term maturities B) Buy short-term maturities C) Buy discount bonds D) Do periodic trading to lock in maturities

B) Buy short-term maturities If an investor buys bonds that have short-term maturities, this will minimize loss in principal due to fluctuating interest rates. The prices of short-term bonds will fluctuate in response to interest rate swings less than the prices of long-term bonds. In addition, premium bonds (those priced above par) are less volatile than discount bonds (those priced below par).

An investor is speculating on the decline in the value of a security and purchases put options on the stock. The news ends up being positive and it results in a rise in the value of the security and the subsequent loss of the entire investment in the put options. This loss is an example of: A) Currency risk B) Capital risk C) Opportunity risk D) Reinvestment risk

B) Capital risk This loss is an example of capital risk. Capital risk is the risk of losing all or part of an investment. Currency risk occurs when the value of foreign currencies change in relation to the value of the U.S. dollar. Falling foreign currency values or rising U.S. dollar values result in a strong dollar. If this happens, the return on foreign investments will fall since the foreign currencies will purchase fewer U.S. dollars on conversion. Reinvestment risk is the result of not being able to reinvest at the same rate after a bond matures or is called. Opportunity risk is the risk that the investment that's chosen will yield less than the yield of another investment that's not chosen.

An individual's close relative, who was a resident of London, England, died six months ago. The client expects to receive an inheritance of a large sum of money. What is the fundamental risk the individual is concerned about? A) Political risk B) Currency risk C) Regulatory risk D) Opportunity risk

B) Currency risk The fundamental risk is currency risk, since the proceeds from the liquidation of the decedent's estate will be paid in British Pounds. At the time of the estate's settlement, if the value of the U.S. dollar is greater than the British Pound, the client will receive fewer U.S. dollars when the British Pounds are converted.

During an inflationary period when interest rates are rising, the market value of existing bonds would: A) Remain stable B) Decrease C) Increase D) Fluctuate

B) Decrease Interest rates and bond prices have an inverse (opposite) relationship. As interest rates rise, bond prices decrease. Therefore, in an inflationary period where interest rates are rising, the market value of existing bonds will decrease.

Which investment has the MOST interest-rate risk? A) Common stock B) High-yield bond fund C) ADR D) Hedge fund

B) High-yield bond fund Interest-rate risk is typically associated with bonds. For that reason, the high-yield bond fund will have more interest-rate risk than any of the other choices.

An investor has a $5 million position in long-term Treasury bonds. Which of the following types of risk is the investor's greatest concern? A) Liquidity risk B) Inflationary risk C) Credit risk D) Prepayment risk

B) Inflationary risk Of the choices listed, the greatest concern is inflationary risk, which is the risk that rising inflation will erode the investor's purchasing power. When a significant amount of money is invested in fixed-income securities, an increase in inflation can have detrimental results.

During a period of rising interest rates, an individual who invests in mortgage-backed securities is MOST concerned with: A) Credit risk B) Opportunity risk C) Legislative risk D) Prepayment risk

B) Opportunity risk Like most debt instruments, mortgage-backed securities (MBSs) are subject to interest-rate risk (i.e., the risk that a debt security's value will fall as interest rates rise). However, during a period of rising interest rates, prepayment risk is less of a factor and opportunity risk becomes more important. Since the existing investments will be earning less than new MBSs, the existing securities could be liquidated at a loss and new MBSs could be purchased to take advantage of their higher return.

An investor has invested in a money market fund that's earning 2%, but is considering an investment in a growth fund that's yielding 8%. By not moving the money into the growth fund, the investor is experiencing: A) Business risk B) Opportunity risk C) Liquidity risk D) Market risk

B) Opportunity risk Opportunity risk (cost) is what an investor forgoes by not taking an alternative course of action. In this situation, the investor is forgoing a potentially higher yield of 6%.

The original asset allocation of an investment portfolio was 10% cash, 40% bonds, and 50% stocks. However, a recent bear market altered this allocation to 10% cash, 50% bonds, and 40% stocks. Since the client's investment objectives and risk tolerance have not changed, which strategy would be used to adjust the asset allocation? A) Buy-and-hold B) Portfolio rebalancing C) Indexing D) Sector rotation

B) Portfolio rebalancing Systematic (portfolio) rebalancing involves the process of buying and selling securities within a portfolio to restore its original asset allocation. Systematic rebalancing may be done either periodically (e.g., quarterly or annually) or whenever market forces or different rates of return cause a significant change in the original asset allocation. In this case, a bear market has caused the value of the stocks in the portfolio to shrink so that this asset class now represents only 40% of the total portfolio. The portfolio would likely be rebalanced by selling bonds and buying stocks with the proceeds.

An investor has recently rolled over $900,000 from a 401(k) plan to an IRA. She's concerned that the market will fall dramatically. About what risk is the investor most concerned? A) Non-systematic risk B) Systematic risk C) Business risk D) Inflation risk

B) Systematic risk Systematic risk is caused by events that will affect all securities. Inflation risk is a type of systematic risk and is experienced when an investor's return doesn't keep up with rising prices (i.e., the rate of inflation). In this question, the investor is worried about all of her investments falling in value, which is referred to as market risk. Business risk is a type of non-systematic risk and only impacts one stock, rather than all stocks.

Which of the following is subject to the LEAST amount of credit risk? A) Corporate bonds B) U.S. Treasury bonds C) Municipal bonds D) Eurodollar bonds

B) U.S. Treasury bonds Credit risk, also referred to as default risk, is the risk that a bond issuer will not make interest and/or principal payments on its bonds. Since U.S. Treasury bonds are backed by the U.S. government, they are considered to have no credit risk.

The value of American depositary receipts is MOST affected by: A) Opportunity risk B) Reinvestment risk C) Currency risk D) Capital risk

C) Currency risk American depositary receipts (ADRs) provide for the trading of foreign securities in U.S. markets. Of the choices given, ADRs will be most affected by currency risk. Currency risk occurs when the value of a foreign currency changes in relation to the value of the U.S. dollar. Falling foreign currency values or rising U.S. dollar values results in a strong dollar. If this happens, the return on foreign investments will fall since the foreign currency purchases fewer U.S. dollars on conversion.

Which of the following risks does NOT apply to both foreign and domestic debt instruments? A) Political B) Repayment C) Exchange D) Interest rate

C) Exchange Exchange (rate) risk could result in investors suffering losses due to a foreign currency losing value against the U.S. dollar. Since foreign debt instruments pay interest and principal in a foreign currency, foreign debt instruments have exchange risk. However, an investor who buys U.S. dollar denominated (domestic) debt is not subject to exchange risk. Interest rate risk is experienced when interest rates rise and prices of bonds fall, which impacts both foreign and domestic bonds. Repayment risk is an issue that impacts both foreign and domestic debt, since both foreign and U.S.-based issuers could default. Political risk could also impact both foreign and U.S. investments.

An investor has adjusted his portfolio based on changes that have been made in the S&P 500 Index. With this information, what types of portfolio strategy is this investor using? A) Asset allocation B) Sector rotation C) Indexing D) Dollar cost averaging

C) Indexing Making adjustments to the investments in a portfolio based on changes that are made to an market index or average is referred to as indexing. Asset allocation is balancing the contents of a portfolio based on the risk tolerance and investment objectives of a client. Sector rotation is an active strategy that involves moving money from one industry to another to beat the return in the market. Dollar-cost averaging follows a regular schedule of investing the same amount of money as the market fluctuates. This avoids timing the market and may result in the average cost per share being less than the average price per share.

An investor who purchases stock in a closely held corporation with a small number of outstanding shares should be MOST concerned about which of the following types of risks? A) Reinvestment B) Regulatory C) Liquidity D) Interest-rate

C) Liquidity Investments in thinly traded issues such as the stock described in the question tend to be illiquid. Investors may have trouble finding buyers for their shares if they need to sell them. This can result in investors either being unable to liquidate their holdings, or having to take a large loss to do so.

An investor who has a diversified portfolio of large-cap stocks could use index options to reduce which of the following risks? A) Timing risk B) Interest-rate risk C) Systematic risk D) Non-systematic risk

C) Systematic risk An investor who wants to hedge a diversified stock portfolio from systematic (market) risk could buy puts or sell call options on the index. If the market declines as a whole, the puts will provide a hedge by becoming more valuable which would offset the risk. In the event the overall market declines, the call options will provide only limited protection through the collection of the premium on the expiration of the options.

A portfolio of debt instruments will be the most stable when: A) Interest rates are decreasing B) Interest rates are increasing C) The bonds have short maturities D) The bonds have long maturities

C) The bonds have short maturities When compared to long-term bonds, short-term bonds are less volatile, tend to have more stable prices, and are one of the safest investments. Based on the inverse relationship between bond prices and interest rates, if interest rates rise, all bond prices will fall and, when interest rates fall, all bond prices will rise. However, long-term bonds will increase or decrease more (i.e., are more volatile) than short-term bonds.

During periods of high inflation, which investments will typically provide the best returns? A) Preferred stocks B) Fixed annuities C) Bonds D) Common stocks

D) Common stocks Common stocks have historically been a hedge against inflation. Investments with a fixed rate of return (e.g., bonds and fixed annuities) typically perform poorly when inflation rises.

During a period of stable interest rates, which type of preferred stock tends to be the most volatile? A) Non-cumulative B) Cumulative C) Participating D) Convertible

D) Convertible Convertible preferred stock may be converted into a fixed number of common shares of the same issuer. For that reason, if the common stock into which the preferred stock may be converted has appreciated above the parity price, the value of the convertible preferred will also rise. During a period of stable interest rates, the other types of preferred stock tend to remain stable.

Which of the following is exposed to the greatest amount of capital risk? A) Common stock B) Corporate bonds C) American depositary receipts D) Equity options

D) Equity options Capital risk is the risk of a person losing all or part of his investment. For options, a relatively small change in the value of the underlying investment can result in the entire loss of an investment in options (i.e., a loss of the option's premium).

A individual has a mix of small-cap growth stocks, large-cap stocks from mature industries, investment-grade bonds, speculative bonds, preferred stock, and foreign securities. She is attempting to reduce: A) Liquidity risk B) Credit risk C) Money-rate risk D) Market risk

D) Market risk Market risk is reduced (not eliminated) by investing in different asset classes. The more random the correlation between the different asset classes, the greater the overall reduction in market risk. A high positive correlation between the asset classes equates to high market risk.

Which statement is TRUE when comparing penny stocks and blue chip stocks? A) Blue chip stocks pay lower dividends than penny stocks B) Both penny stocks and blue chip stocks have currency risk C) Blue chip stocks have more business risk than penny stocks D) Penny stocks are less liquid than blue chip stocks.

D) Penny stocks are less liquid than blue chip stocks. Penny stocks are not listed on traditional stock exchanges and are less liquid than blue chip stocks. Blue chip stocks typically pay higher dividends than penny stocks. Currency risk is typically only associated with foreign investments.

A country is experiencing economic difficulties as a result of pressure being put on the government by numerous parties. The negative impact on the economy is the result of: A) Business risk B) Legislative risk C) Regulatory risk D) Political risk

D) Political risk Political risk is the risk that foreign investors will lose money due to changes that occur in the country's government or regulatory environment. Business risk is when certain factors will impact a specific company. Legislative risk is the risk that changes in laws may have a negative impact on an investment's value. Regulatory risk is when a change in regulations may have a negative impact on an investment's value.

Which of the following is not considered a form of systematic risk? A) Market risk B) Interest-rate risk C) Inflation risk D) Regulatory risk

D) Regulatory risk Regulatory risk is a form of diversifiable risk. If regulators establish new environmental rules, it will help some companies, but will negatively impact others. Systematic risk, also referred to as non-diversifiable risk, is risk that's common to an entire class of assets or liabilities. The value of investments may decline over a given period simply due to economic changes or other events that impact large portions of the market. Some systematic risks include market risk, interest-rate risk, and inflation risk.

A security with a low beta: A) Outperforms the market when it is gaining and losing B) Underperforms the market when it is gaining and losing C) Outperforms the market when its gaining and underperforms the market when its losing D) Underperforms the market when its gaining and outperforms the market when its losing

D) Underperforms the market when its gaining and outperforms the market when its losing Beta measures a security's volatility in relation to the market. A security's beta is compared to the beta of the market (i.e., the S&P 500), which has a beta of 1. A stock with a low beta (less than 1) is less sensitive to market movements. In a rising market, a low-beta security will lag in performance. However, when prices are declining, this security will do better since it will generally fall less than the market. On the other hand, a stock with a high beta (greater than 1) will be more sensitive to market movements. A high-beta stock will rise and fall faster than the overall market.

Crunch Time Fact #6

Political risk, repayment risk, and interest-rate risk applies to both domestic and foreign bond investments; however, exchange risk applies to foreign bond investments only.

Crunch Time Fact #7

To create a downside risk hedge, an investor who owns 100 shares of ABC at $40 buys 1 ABC July 40 put at 3. To breakeven, the investor needs ABC stock to be trading at $43 ($40 cost of the stock plus the $3 premium paid).