Unit 11 Types of Investment Risks (6)

If a customer is concerned about interest rate risk, which of the following securities is least appropriate? A) 5-year corporate bonds B) Treasury bills C) 25-year municipal bonds D) 10-year corporate bonds

C. Interest rate risk is the danger that interest rates will rise and adversely affect a bond's price. This risk is greatest for long-term bonds; short-term debt securities are affected the least if interest rates change. U11LO1

A risk-averse client, living in the United States and holding a high proportion of his assets in cash and cash equivalents in U.S. dollars, is exposed to which of the following risks? A) Purchasing power risk B) Market risk C) Exchange rate risk D) Reinvestment rate risk

A. Although cash and cash equivalents (money market instruments) may assist in managing liquidity risk, they do have purchasing power, or inflation risk, because they have limited opportunity for capital appreciation. Exchange rate, (currency risk) risk does not apply because this is a U.S. client with investments denominated in dollars. There is no market risk to cash and virtually none to cash equivalents. There is nothing to reinvest with cash, and the returns and maturities on cash equivalents are such that reinvestment risk is not a concern. U11LO1

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 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. U11LO1

Which of the following statements regarding investment risk is NOT correct? A) The beta coefficient measures an individual stock's relative volatility to the market. B) A stock's level of risk is a combination of market risk and diversifiable risk. C) Systematic risk may be reduced or eliminated by effective portfolio diversification. D) Investors expect to earn a higher rate of return for assuming a higher level of risk.

C. Unsystematic (diversifiable) risk may be effectively managed through portfolio diversification. U11LO2

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

C. 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. U11LO1

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

D. 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. U11LO2

Which of the following is a risk common to all fixed-income securities? A) Market risk B) Liquidity risk C) Opportunity cost D) Interest rate risk

D. One of the characteristics of all fixed income securities is that the income never changes (fixed), so when interest rates change, the income of those securities can't follow along. Therefore, one risk common to all fixed-income securities is interest rate risk. U11LO1

Which of the following securities are the most interest rate sensitive? Utility stocks Growth stocks Preferred stocks Common stocks A) III and IV B) II and IV C) I and II D) I and III

D. Utility and preferred stocks are the most interest rate sensitive. Utility stocks are interest rate sensitive because they are highly leveraged. Preferred stocks are interest rate sensitive because they have a set dividend and fluctuate in price like bonds when interest rates change. U11LO1

An investor's portfolio that consists of all long-term Treasury bonds is most vulnerable to which of the following types of risk? A) Business risk B) Marketability risk C) Interest rate risk D) Default (credit) risk

The client is most exposed to interest rate risk because a rise in interest rates would cause a decline in the value of the long-term bonds. This client is also exposed to inflation, or purchasing power risk. There is very little marketability (liquidity) risk and no-default (credit) risk. U11LO1

What is most likely to happen to outstanding fixed-income securities when interest rates decline? A) Yields go up B) Coupon rates go up C) Prices go up D) No change

When interest rates drop, prices will rise, decreasing effective yield. Thus, there is an inverse relationship between interest rates and bond prices. U11LO1