Suitability: Analyzing Financial Risks and Rewards Flashcards
Which of the following bonds is most affected by interest rate risk?
A)
7.5s of ‘24 yielding 7.2%.
B)
7s of ‘22 yielding 7%.
C)
7.6s of ‘31 yielding 7.2%.
D)
7.8s of ‘27 yielding 7.3%.
C)
7.6s of ‘31 yielding 7.2%.
Explanation
Interest rate risk is the loss in value due to a rise in interest rates. Since there is little difference in coupon rates, the bond with the longest maturity (highest duration) will experience the greatest fall in a rising interest rate market.
Reference: 15.3.2.4 in the License Exam Manual
In a rising market, which of the following is least volatile?
A)
A stock with a beta of 2.0.
B)
A stock with an alpha of 0.5.
C)
A stock with a beta of 0.5.
D)
A stock with an alpha of 2.0.
A stock with a beta of 0.5.
Explanation
Beta is a measure of a stock’s volatility relative to the overall market, as measured by the S&P 500. A stock with a beta of 2.0 will move twice as fast as the overall market, while a stock with a beta of 0.5 will move half as fast as the overall market.
Reference: 15.3.3.1 in the License Exam Manual
If a customer is concerned about interest rate risk, which of the following securities is least appropriate?
A)
Treasury bills.
B)
10-year corporate bonds.
C)
5-year corporate bonds.
D)
25-year municipal bonds.
D)
25-year municipal bonds.
Explanation
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.
Reference: 15.3.2.4 in the License Exam Manual
Which of the following statements is NOT true?
A)
A stock with a beta of 1.2 will move 20% more than the market.
B)
Beta is a measure of a security’s deviation from its historical average returns.
C)
Beta is a volatility measure of a security compared with the overall market.
D)
A stock with a beta of .8 will move 20% less than the market.
Beta is a measure of a security’s deviation from its historical average returns.
planation
A measure of a security’s deviation from its historical average returns is the security’s standard deviation. Beta measures a security’s volatility in relation to the overall market. Stocks with a beta greater than 1 are more volatile than the market and stocks with a beta less than 1 are less volatile than the market.
Reference: 15.3.3.1 in the License Exam Manual
Question #5 of 38
Question ID: 607156
Which of the following statements are TRUE?I. Systematic risk can be diversified away.
II. Systematic risk cannot be diversified away.
III. Nonsystematic risk can be diversified away.
IV. Nonsystematic risk cannot be diversified away
A)
II and III.
Explanation
Systematic risk, which affects all investments, cannot be diversified away. Nonsystematic risk, or company risk, can.
Reference: 15.3.2.7 in the License Exam Manual
Question #6 of 38
Question ID: 607180
Rank the following from the safest to the most risky.I. AAA-rated corporate bonds.
II. Blue-chip stocks.
III. U.S. government securities.
IV. Tech stocks.
D)
III, I, II, IV.
Explanation
It should be obvious that U.S. government securities would be first and tech stocks last. As for options II and III, stocks will fluctuate more in price than highly rated corporate bonds.
Reference: 15.3 in the License Exam Manual
Question #9 of 38
Question ID: 901873
An investor, age 57, wants to amend an existing portfolio to have a greater percentage be in fixed income (debt) instruments. Current market sentiment is that interest rates are very high and likely to begin contracting soon. This investor agrees and asks for your thoughts regarding what those debt instruments might be. Aligning with the market sentiment the most suitable would be
A)
money market fund
B)
non-callable corporate bonds
C)
callable corporate bonds
D)
variable rate municipal bonds
B)
non-callable corporate bonds
Explanation
If one anticipates that interest rates will be falling, non-callable bonds would be better as there is no risk of them being called and you can continue to earn the higher rate the bonds were issued with. Anything with a variable rate will have the interest payable adjusted to align with current rates and therefore not desirable when rates are falling. Money market funds are not debt instruments and again the returns they pay reflect trending interest rates.
Reference: 15.3.2.6 in the License Exam Manual
Most rating services rate which of the following?
A)
Quality.
B)
Marketability.
C)
Durability.
D)
Reinvestment risk.
A)
Quality.
Explanation
The rating services are concerned with quality, which is defined as the ability of the issuer or guarantor to pay (default risk).
Reference: 15.3.2.8 in the License Exam Manual
An investor’s portfolio has a beta coefficient of .85. If the overall market declined by 10% over the course of a year, the portfolio’s value has likely:
A)
decreased by 11.76%.
B)
decreased by 8.5%.
C)
increased by 8.5%.
D)
increased by 10.85%.
B)
decreased by 8.5%.
Explanation
A beta coefficient of .85 means that the portfolio is considered to be .85 times as volatile as the overall market. Therefore, if the market declines by 10%, the portfolio with a beta of .85 is likely to decline by only 8.5% (.10 × .85).
Reference: 15.3.3.1 in the License Exam Manual
Which of the following provides a measurement of the volatility of a particular stock or portfolio as compared to the volatility of the market as a whole?
Beta.
Explanation
The beta value is an index that measures the volatility of a stock’s or portfolio’s movement as compared to the movement of the market as a whole. By definition, the beta of the market is equal to 1.0.
Explanation
The beta value is an index that measures the volatility of a stock’s or portfolio’s movement as compared to the movement of the market as a whole. By definition, the beta of the market is equal to 1.0.
B)
increase by $2,500.
Explanation
A stock with a beta coefficient of 1.25 could be expected to rise in value at a rate 25% greater than the overall market. Since the market has increased by 10%, this stock should increase by 12.5% or $2,500 (10% × 1.25 × $20,000 = $2,500).
Reference: 15.3.3.1 in the License Exam Manual
Which of the following statements is TRUE?
A)
Both ALPHA and BETA are measures of volatility only and neither measures performance.
B)
Both ALPHA and BETA each use different measures of overall performance expectations but cannot be used to measure volatility.
C)
A measure of a stock or portfolio’s volatility is BETA and a measure of its performance is ALPHA.
D)
A measure of a stock or portfolio’s volatility is ALPHA and a measure of its performance is BETA.
C)
A measure of a stock or portfolio’s volatility is BETA and a measure of its performance is ALPHA.
A stock’s BETA is a measure of its volatility in relation to the overall market. While ALPHA is a measure of performance that adjusts for risk, relative to a known benchmark.
Reference: 15.3.3.1 in the License Exam Manual
Which of the following best describes the investment characteristics of a high-quality long-term municipal bond?
C)
High inflation risk; low default risk.
Explanation
A longer-term bond will be subject to more inflation risk. Since the quality of the bond is high, the level of default risk should be low.
Reference: 15.3.2.1 in the License Exam Manual
Which of the following best describes ALPHA for an investor’s portfolio?
A)
It is a measure of performance that adjusts for risk, relative to a known benchmark.
B)
It is a measure of risk that adjusts in accordance with the performance of a known benchmark.
C)
It is the prediction of performance aligning with the risk of a known benchmark.
D)
It is a measure of each portfolio assets risk to arrive at the risk associated with the entire portfolio.
Explanation
ALPHA is a measure of performance that adjusts for risk, relative to a known benchmark. The ALPHA for any investment type, a particular asset, or portfolio is the abnormal rate of return on the investment in relation to what would normally be predicted by the benchmark.
Reference: 15.3.3.1 in the License Exam Manual
A portfolio manager using index options is trying to reduce which of the following types of risks?
A)
Purchasing power.
B)
Systematic.
C)
Financial.
D)
Selection.
Explanation
Systematic risk (sometimes called systemic risk) refers to the impact the overall market has on an equity portfolio’s value. Index options help insure portfolios against systematic risk. The purchase of index puts to protect a portfolio is termed portfolio insurance.
Which of the following are likely to have a low beta?
Public utility stocks.
Explanation
Public utility stocks tend to have low betas as do other defensive stocks. Technology, aerospace, and software stocks tend to have high betas.
Reference: 15.3.3.1 in the License Exam Manual
Which of the following statements regarding nonsystematic risk are TRUE?I. It is the risk that an individual stock will not perform well.
II. It is the same as market risk.
III. Diversification reduces it.
IV. Diversification does not reduce it.
C)
I and III.
Explanation
Nonsystematic risk is company risk, the risk that an individual investment will perform poorly. Diversification can reduce most nonsystematic risks.
Reference: 15.3.2.7 in the License Exam Manual
Reinvestment risk is the chance that, after purchasing a bond, interest rates:
A)
become volatile.
B)
fall.
C)
rise.
D)
remain stable.
Explanation
Reinvestment risk is the danger that after purchasing a bond, interest rates will fall. This means that the fixed interest payments received over the remaining life of the bond will be reinvested at lower rates. The good news is that the price of the bond has probably risen due to falling rates.
Reference: 15.3.2.5 in the License Exam Manual
Traders in stock index options are exposed to:
A)
call risk.
B)
credit risk.
C)
systematic risk.
D)
redemption risk.
systematic risk.
Explanation
Systematic risk is the possibility that an overall decline in the market will cause a loss in an investment. Index options investors are exposed to the risk that market movement will cause the option positions to move adversely.
Reference: 15.3.2.7 in the License Exam Manual
A customer, age 72, retired and on a fixed income wants to invest $50,000 in small-cap stocks in an account set up as JTWROS with a spouse. As a registered representative you feel the transactions to be unsuitable for the customer. Therefore you should:
A)
discuss with the customer why small-cap stocks might not be appropriate given the circumstances as you know them before entering any orders.
B)
enter the trade without question or discussion.
C)
refuse the trade as unsuitable.
D)
require documentation from the other party to the JTWROS account showing they agree with the proposed transactions.
A)
discuss with the customer why small-cap stocks might not be appropriate given the circumstances as you know them before entering any orders.
Explanation
If a registered representative (RR) feels the proposed transactions might not be suitable for the customer there is no obligation by industry rule to refuse the trade but there is however a responsibility to explain so to them before entering any orders. In a JTWROS account either party may enter trades without the prior consent of the other party
Which type of risk is a mortgage-backed security most likely to experience?
A)
Exchange rate risk.
B)
Market risk.
C)
Reinvestment rate risk.
D)
Business or corporate risk.
C)
Reinvestment rate risk.
Explanation
A mortgage-backed security, such as a collateralized mortgage obligation (CMO), is most likely to experience reinvestment rate risk. As mortgages are paid off early and refinanced in the event of declining interest rates, the interim cash flows received from the obligation must be reinvested in lower yielding securities. This is the practical effect of prepayment risk.
Your client is interested in a direct participation program (DPP) limited partnership. Which of the following two are most likely to factor into a discussion on suitability of such an investment? I.Beta.
II.Liquidity.
III.Alpha.
IV.Age.
A)
II and IV.
B)
I and IV.
C)
I and III.
D)
II and III
A) II and IV.
The key here is to recognize that with DPPs, the customer’s age is a relevant consideration in determining suitability. DPPs are long-term and illiquid. For example, it is unlikely that DPPs would be suitable for a customer near retirement age, regardless of the customer’s financial situation. Beta, having to do with measuring an investment’s volatility as related to the overall market, and alpha being a measure of performance adjusted for risk are not factors generally associated with DPPs.
If near term liquidity were the only objective for a client, which of the following pairs of investments would represent the most/least liquid?
A)
Variable annuity (VA)/direct participation programs
B)
10-year corporate bonds/U.S. T-bills
C)
Variable annuity (VA)/money market mutual funds
D)
Exchange listed equities/direct participation program (DPP)
C)
Variable annuity (VA)/money market mutual funds
Explanation
Of the pairings offered to choose from, exchange listed equities are considered liquid as they could be easily divested of, and DPPs all having predetermined (scheduled) end dates, would be the least liquid.
Reference: 15.3.2.9 in the License Exam Manual
The risk of a bond decreasing in value during periods of inflation is known as:
A)
credit risk.
B)
reinvestment risk.
C)
interest rate risk.
D)
marketability risk.
C) interest rate risk.
Explanation
Interest rate risk is the possibility that interest rates might rise, causing bond prices to fall. Periods of inflation are accompanied by rising interest rates.
Reference: 15.3.2.4 in the License Exam Manual
If your customer is pursuing an aggressive stock buying strategy, which of the following is most suitable for him?
A)
GHI stock with a beta coefficient of 1.20.
B)
ABC stock with a beta coefficient of 1.0.
C)
DEF stock with a beta coefficient of .93.
D)
Convertible bonds of a mid-cap company.
A)
GHI stock with a beta coefficient of 1.20.
Explanation
Beta coefficients greater than 1.0 signify that the stock will fluctuate more than the market as a whole. In general, the higher the beta is, the greater the risk. Such risk-taking is appropriate for investors who seek aggressive stock-buying strategies and have both the financial ability and the temperament to withstand downturns in the market.
Reference: 15.3.3.1 in the License Exam Manual
Credit risk involves:
A)
fluctuations in overall interest rates.
B)
inflationary risks.
C)
possibility of issuer default.
D)
danger of not being able to sell the investment at a fair market price.
C)
possibility of issuer default.
Explanation
Credit risk is the danger of losing all or part of the invested principal as the result of the issuer’s failure.
Question #34 of 38
Question ID: 607179
A wealthy client owns a large percentage of a thinly traded common stock. When this client wants to sell a major portion of his securities, he will immediately face:
A)
credit risk.
B)
marketability risk.
C)
interest rate risk.
D)
market risk.
B)
marketability risk.
It is difficult to sell a large block of securities in a thinly traded stock without a substantial discount to market price. This is known as liquidity or marketability risk.
Reference: 15.3.2.9 in the License Exam Manual
Your customer’s portfolio consists of 40% long-term government bonds, 20% preferred stock, and 40% common shares of utility companies. Which of the following may have the single largest impact on the entire portfolio?
A)
Interest rate movements
B)
Foreign currency fluctuations
C)
Corporate earnings
D)
Oil and gas price movements
A)
Interest rate movements
Explanation
Of the four answer choices, interest rate movement is the most likely to impact each of the portfolio components. Interest rates and bond prices have an inverse relationship, and their movement often determines whether investors might seek out investment alternatives with higher returns, such as dividend paying utilities and fixed dividend preferred shares.
