C.18 Analysis and evaluation of risk exposures

Question 1

Which of the following is a measure of the likelihood of an event occurring?

A. Risk tolerance
B. Risk perception
C. Risk probability
D. Risk mitigation

Answer 1

C. Risk probability

Risk probability is a measure of the likelihood of an event occurring, and is a key component of risk analysis.

C.18 Analysis and evaluation of risk exposures

Question 2

Which of the following is a method of reducing risk exposure through diversification?

A. Hedging
B. Insurance
C. Risk pooling
D. Asset allocation

Answer 2

D. Asset allocation

Asset allocation is a method of reducing risk exposure through diversification, by spreading investments across different asset classes and sectors.

C.18 Analysis and evaluation of risk exposures

Question 3

Which of the following is an example of a systematic risk?

A. Interest rate risk
B. Company-specific risk
C. Credit risk
D. Liquidity risk

Answer 3

A. Interest rate risk

Systematic risk is the risk inherent to the entire market or market segment, and cannot be diversified away. Interest rate risk is an example of systematic risk.

C.18 Analysis and evaluation of risk exposures

Question 4

Which of the following is an example of a credit risk?

A. The risk of a company’s stock price declining
B. The risk of a bond issuer defaulting on interest payments
C. The risk of a natural disaster damaging a company’s facilities
D. The risk of a sudden drop in the value of a currency

Answer 4

B. The risk of a bond issuer defaulting on interest payments

Credit risk is the risk that a borrower will default on their debt obligations. The risk of a bond issuer defaulting on interest payments is an example of credit risk.

C.18 Analysis and evaluation of risk exposures

Question 5

Which of the following is a method of reducing risk exposure through the use of financial contracts?

A. Hedging
B. Insurance
C. Risk pooling
D. Asset allocation

Answer 5

A. Hedging

Hedging is a method of reducing risk exposure through the use of financial contracts, such as futures contracts, options, or swaps.

C.18 Analysis and evaluation of risk exposures

Question 6

Which of the following is a measure of the potential loss that could result from an adverse event?

A. Risk perception
B. Risk probability
C. Risk tolerance
D. Risk exposure

Answer 6

D. Risk exposure

Risk exposure is a measure of the potential loss that could result from an adverse event, and is an important component of risk management.

C.18 Analysis and evaluation of risk exposures

Question 7

Which of the following is a measure of the volatility of an investment?

A. Expected Return
B. Standard deviation
C. Sharpe ratio
D. Beta

Answer 7

B. Standard deviation

Standard deviation is a measure of the volatility of AN investment. It quantifies how much the returns of an investment vary from the average return over a specific period. A higher standard deviation indicates greater volatility, implying that the investment’s returns are more spread out and less predictable. Investors often use standard deviation as a risk metric to assess the level of uncertainty or potential for large price swings associated with an investment.

C.18 Analysis and evaluation of risk exposures

Question 8

Which of the following is a measure of the risk-adjusted return of an investment?

A. Expected Return
B.Standard deviation
C. Sharpe ratio
D. Beta

Answer 8

C. Sharpe ratio

The Sharpe ratio is a measure of the risk-adjusted return of an investment, and takes into account both the expected return and the risk (as measured by the standard deviation) of an investment.

C.18 Analysis and evaluation of risk exposures

Question 9

Which of the following is a type of risk that can be diversified away?

A. Systematic risk
B. Credit risk
C. Market risk
D. Company-specific risk

Answer 9

D. Company-specific risk

Company-specific risk is the risk that is specific to an individual company, and can be diversified away by investing in a portfolio of different companies.

C.18 Analysis and evaluation of risk exposures

Question 10

Which of the following is an example of an operational risk?

A. The risk of a stock market crash
B. The risk of a natural disaster
C. The risk of a cyber attack
D. The risk of a change in government policy

Answer 10

C. The risk of a cyber attack

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events. The risk of a cyber attack is an example of operational risk.

C.18 Analysis and evaluation of risk exposures

Question 11

Which of the following is a method of measuring risk that takes into account the potential losses beyond a certain threshold?

A. Value at Risk (VaR)
B. Conditional Value at Risk (CVaR)
C. Expected Shortfall
D. Monte Carlo simulation

Answer 11

B. Conditional Value at Risk (CVaR)

Conditional Value at Risk (CVaR), also known as Expected Shortfall, is a method of measuring risk that takes into account the potential losses beyond a certain threshold, and is commonly used in risk management.

C.18 Analysis and evaluation of risk exposures

Question 12

Carlos, a Certified Financial Planner CFP®, is advising his client, Angela Ramirez, who is an executive at a multinational technology firm. Angela has a substantial number of stock options in her company. She is optimistic about the long-term prospects of the firm but is concerned about the short-term volatility in the tech sector that could significantly affect her stock options’ value. Carlos suggests a strategy to mitigate this type of financial risk without selling her stock options. Which of the following strategies should Carlos recommend to Angela to reduce the potential short-term risk to her stock options?

A. Diversify her investment portfolio by purchasing mutual funds.
B. Obtain an insurance policy against the loss of value in her stock options.
C. Use financial derivatives as a hedging strategy to offset potential losses.
D. Engage in risk pooling with other executives holding similar stock options.

Answer 12

C. Use financial derivatives as a hedging strategy to offset potential losses.

Hedging is a risk management strategy used to offset potential losses in one position by taking an opposite position in a related asset. In this scenario, Angela can hedge her position by using financial derivatives such as options or futures contracts. This would allow her to protect against the downside risk of her stock options while maintaining the potential for upside gain if the company’s stock performs well.

C.18 Analysis and evaluation of risk exposures

Question 13

Michael is a Certified Financial Planner CFP® preparing an investment strategy for his client, Linda, who is keen on understanding how her potential investment in XYZ Tech Inc. would react to market movements. She wants to ensure that her investment portfolio is aligned with her moderate risk tolerance level. Michael decides to illustrate a concept that measures the sensitivity of XYZ Tech Inc. stock to the fluctuations in the broader technology sector index.

Which of the following measures should Michael explain to Linda to help her understand how sensitive the XYZ Tech Inc. stock is to market movements?

A. Expected Return
B. Standard deviation
C. Sharpe ratio
D. Beta

Answer 13

D. Beta

Beta is a measure of the sensitivity of an investment to movements in the market or a particular benchmark. A beta of 1 indicates that the investment’s price will move with the market, a beta of more than 1 indicates that the investment is more volatile than the market, and a beta of less than 1 indicates that the investment is less volatile than the market. Since Linda is concerned with how the stock of XYZ Tech Inc. will react to market changes, beta is the appropriate measure to consider in this scenario.

C.18 Analysis and evaluation of risk exposures

Question 14

Martha, a CFP® professional, is advising Thomas on his investment portfolio. Thomas is concerned about the recent volatility in the stock market and wants to know more about the kinds of risks he cannot avoid, even if he diversifies his portfolio across various asset classes and industries. Martha explains that while diversification can help reduce some risks, there is one particular type of risk that remains unaffected by such strategies. Which of the following types of risk is Martha referring to?

A. Systematic risk
B. Credit risk
C. Market risk
D. Company-specific risk

Answer 14

A. Systematic risk

Systematic risk, also known as market risk, is inherent to the entire market or market segment and cannot be eliminated through diversification. It is caused by external factors such as political, economic, and social changes that affect the entire market. This is different from company-specific risk (also known as unsystematic risk), which can be mitigated through diversification. Credit risk is associated with the possibility of a loss resulting from a borrower’s failure to repay a loan or meet contractual obligations, and while it can be reduced by diversifying among different borrowers and industries, it does not describe the risk inherent to the market as a whole.

C.18 Analysis and evaluation of risk exposures

Question 15

Margaret is a financial planner advising Thomas, a 64-year-old client who is planning to retire within the next year. Thomas has expressed a desire to preserve his capital and has a low tolerance for risk. He has a pension and social security that will cover his basic expenses, but he has an additional $300,000 that he wants to invest to provide some supplementary income while also maintaining the principal. Which of the following investment options should Margaret recommend to Thomas?

A. Corporate junk bonds offering 9% annual yield
B. Blue-chip company stocks with a history of stable dividends
C. 6-month U.S. Treasury bills
D. Stocks in fast-growing companies from developing countries

Answer 15

C. 6-month U.S. Treasury bills

Thomas, who is close to retirement and has a low-risk tolerance, would be best suited with an investment that is low risk and provides a stable, reliable return. 6-month U.S. Treasury bills (T-bills) are considered one of the safest investments because they are backed by the full faith and credit of the U.S. government. They provide a fixed rate of interest and return the principal upon maturity, aligning with Thomas’s goal of capital preservation and a supplementary income without risking the principal.

C.18 Analysis and evaluation of risk exposures

Question 16

A manufacturing company is considering a new project that will require a significant amount of investment. The project has a high potential return, but also comes with a high level of risk. What should the company do?

A. Reject the project due to the high level of risk
B. Proceed with the project and accept the risk
C. Hedge the risk through the use of financial derivatives
D. Diversify the investment portfolio to reduce the overall risk

Answer 16

C. Hedge the risk through the use of financial derivatives

If a company faces a high level of risk for a project that has a high potential return, they may consider hedging the risk through the use of financial derivatives. This allows the company to protect themselves against adverse movements in the market and reduce their risk exposure.

C.18 Analysis and evaluation of risk exposures

Question 17

A portfolio manager is analyzing the risk exposure of a fund that invests in a variety of stocks. The manager is concerned that the fund may be overly exposed to a particular industry that is experiencing a downturn. What should the manager do?

A. Sell all of the stocks in the underperforming industry
B. Reduce the exposure to the underperforming industry by selling some of the stocks
C. Increase the exposure to the underperforming industry by buying more stocks
D. Hold onto the stocks and wait for the industry to recover

Answer 17

B. Reduce the exposure to the underperforming industry by selling some of the stocks

If a portfolio manager is concerned about an overly high exposure to a particular industry that is experiencing a downturn, they may consider reducing the exposure by selling some of the stocks. This reduces the risk exposure to the underperforming industry while still maintaining some exposure to the overall market.

C.18 Analysis and evaluation of risk exposures

Question 18

Alexis, a hedge fund manager, is evaluating a potential investment in InnovTech, a startup that has developed an advanced AI-driven analytics platform. While the startup’s innovative technology has the potential to disrupt the market and yield high returns, the investment also carries significant risk because the technology has not yet been widely adopted. Alexis wants to mitigate the potential risks associated with this high-stakes investment. Which of the following strategies should Alexis employ to manage the risk?

A. Decline the investment opportunity due to the unproven nature of the product.
B. Invest in InnovTech and fully embrace the associated risks.
C. Use financial derivatives to hedge against the specific risks of the investment.
D. Spread the investment across a broader range of assets to lower the fund’s overall exposure to risk.

Answer 18

D. Spread the investment across a broader range of assets to lower the fund’s overall exposure to risk.

Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. By diversifying, Alexis can reduce the fund’s overall risk because the various investments will, on average, yield higher returns and lower risk than any individual investment within the portfolio. This strategy does not eliminate risk, but it can reduce the impact of any one investment’s poor performance on the overall portfolio. Using financial derivatives as mentioned in option C) is also a strategy to hedge risk, but it would be more applicable if Alexis were looking to protect against specific risks to the investment in InnovTech rather than seeking to manage the overall risk exposure of the hedge fund’s portfolio.

C.18 Analysis and evaluation of risk exposures

Question 19

Linden Investment Bank is evaluating a potential investment in Vertex Technologies, a firm whose stock price has plummeted by 40% in the past six months. Despite the decline, Vertex’s fundamentals appear strong, and Linden’s analysis suggests that the stock is currently undervalued, offering a potentially high return. Aware of the risks inherent in such a volatile investment, Linden is considering the best strategy to manage the potential risk associated with a sizeable investment in Vertex. Which of the following strategies should Linden Investment Bank employ?

A. Decline the investment in Vertex Technologies due to the inherent high risks.
B. Invest in Vertex Technologies and accept the associated high level of risk as part of its investment strategy.
C. Utilize financial derivatives to hedge against the specific risks of investing in Vertex Technologies.
D. Broaden its investment portfolio to include a variety of assets, thereby reducing the impact of the risk of investing in Vertex Technologies.

Answer 19

C. Utilize financial derivatives to hedge against the specific risks of investing in Vertex Technologies.

In this scenario, hedging is the most appropriate strategy for managing the risk of a single, potentially volatile investment. By using financial derivatives such as options or futures, Linden Investment Bank can mitigate the risks associated with the investment in Vertex Technologies. Hedging allows the bank to protect itself against potential losses from the specific investment while still maintaining the possibility of benefiting from the potential upside if the analysis is correct and the stock is truly undervalued. Options like buying puts on Vertex stock or entering into futures contracts can provide a safety net, thus enabling Linden to pursue the high-return opportunity without bearing the full brunt of the risk should their assessment prove incorrect. This approach does not mean the bank avoids risk entirely but manages it in a strategic manner.

C.18 Analysis and evaluation of risk exposures

Question 20

Jennifer, a newly-certified financial planner, is discussing various financial models with her colleague, Derek. Derek mentions the differences between the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT). Which of the following statements correctly identifies a difference between the two models?

A. APT incorporates multiple factors in its model, whereas CAPM is based on a single factor.
B. CAPM delves deeper into market intricacies than the APT model.
C. CAPM operates on the premise that ideal substitutes should transact concurrently.
D. The APT model offers more straightforward application since its factors/betas originate from economic sources.

Answer 20

A. APT incorporates multiple factors in its model, whereas CAPM is based on a single factor.

CAPM is a single-factor model that links expected security returns to market returns. The only factor in this model is the market risk premium. On the other hand, APT is a multi-factor model, allowing for multiple sources of systematic risk that can affect a security’s return. This is why option A correctly identifies a difference between the two models.

C.18 Analysis and evaluation of risk exposures