Types of Investment Risk

Question 1

Systematic Risk

Answer 1

• risk that is associated with the entire market, such as market risk, interest rate risk, purchasing power risk, exchange rate risk, and reinvestment rate risk.
• it cannot be diversified away because it affects the entire market.
• Beta is used to measure the amount of systematic risk that the investor has assumed (only viable if used for the entire portfolio)

Question 2

Purchasing Power Risk

Answer 2

• systematic risk
• the risk that inflation will erode the real value of the investor’s assets.
• bonds held to maturity are likely to suffer from purchasing power risk because the maturity value will remain the same.

Question 3

Reinvestment Rate Risk

Answer 3

• systematic risk
• the part of interest rate risk resulting from uncertainty about the rate at which future interest coupons will be reinvested.
• callable bonds are most impacted by reinvestment rate risk, although the price of mortgage backed securities are also influenced.

Question 4

Interest Rate Risk

Answer 4

• systematic risk
• the risk that changes in interest rates will affect the value of securities.
• rising interest rates will have a negative effect on stocks because the increased discount rate for valuation of cash flows, increased borrowing costs, and increased yields on alternative investments.

Question 5

Market Risk

Answer 5

• systematic risk
• the tendency for stocks to move with the market.
• the investor cannot reduce this market risk of loss by increasing the number of companies whose common stocks are in his portfolio because the market prices of equities tend to rise or fall together.

Question 6

Exchange Rate Risk

Answer 6

• systematic risk

- the variability in returns on securities caused by currency fluctuations.

Question 7

Bond Interest Rate Risk

Answer 7

• the longer the bonds term to maturity, the greater its interest rate risk
• the lower the bond’s coupon rate, the greater its interest rate risk
• the lower the bond’s yield to maturity, the greater its interest rate risk.

Question 8

Unsystematic Risk

Answer 8

• risk that affects only a single asset or small group of assets.
• since the risk is only specific to an individual company or industry, it may be diversified away.

Question 9

Business Risk

Answer 9

• unsystematic risk
• the amount of investment risk inherent in company operations
• a corollary to business risk in some firms is its financial risk.

Question 10

Financial Risk

Answer 10

• unsystematic risk
• the additional risk placed on the common stockholders of a company as a result of its decision to use debt (bonds) as part of its capital structure.
• the additional risk that the stockholders of a leveraged company assumes, in excess of the risk assumed if the company uses no debt in its capital structure, is the company’s financial risk.

Question 11

Political/Regulatory Risk

Answer 11

-unsystematic risk
-the possibility of expropriation and the unanticipated restriction of an investors cash flows by a foreign govt.
-

Question 12

Liquid Asset

Answer 12

-assets that can be readily converted into cash without a significant loss to principal.

Question 13

marketability

Answer 13

• the speed and ease with which a security may be bought and sold.
• An actively traded stock that has a large number of shares outstanding is highly marketable, but is generally not liquid.

Question 14

Planners recommendations about liquidity

Answer 14

1) the clients life cycle position
2) The clients near term financial goals
3) the rate of return required by the client to meet financial goals
4) the clients wishes
5) the clients health

Question 15

ranking of liquidity (descending order)

Answer 15

1. savings accounts
2. treasury bills
3. CD’s
4. High grade common stocks
5. high grade corporate bonds
6. high grade tax exempt bonds
7. high grade preferred stock
8. speculative common stock
9. puts and calls
10. futures contracts
11. speculative corporate bonds
12. speculative tax-exempt bonds
13. real estate
14. collectibles and physical assets
15. limited partnership interests