Types of Risk and Diversification Practice Questions
1. Identify the correct statements regarding investment risks from the following:
I. Beta is a measure of systematic, non-diversifiable risk
II. Market risk is the same as unsystematic risk;
III. Standard deviation can be used to measure of total risk;
IV. Diversification can help significantly reduce unsystematic risks
I, II, and IV
II, III, and IV
I, III and IV
I and II only
2. Investors usually invest in mutual funds as a common tactic to diversify and reduce which of the following risks?
A. Purchasing power risk
B. Reinvestment rate risk
C. Interest rate risk
D. Business risk
3. An investor who decides to buy and hold a corporate bond till it matures would be exposed to all risks EXCEPT:
A. Interest rate risk
B. Call risk
C. Inflationary Risk
D. Credit risk
4. Identify from the following risks, those that can be listed as unsystematic risks
I Regulation Risk
II Default Risk
III Market Risk
IV Business Risk
A. I, II, III, IV
B. II and IV only
C. I and II only
D. I, II, and IV
5. When a government considers changing its federal policy on how it taxes municipal bond income; this creates what type of risk?
A. Liquidity risk
B. Exchange rate risk
C. Default risk
D. Regulatory risk
6. What risk is associated with trading in “thinly held issues” or issues that lack marketability?
A. Default Risk
B. Business Risk
C. Exchange Rate Risk
D. Liquidity Risk
7. Stocks with negative alpha are considered to be over priced or over valued, while stocks with a positive alpha are thought to be undervalued or under-priced. When one is analyzing the alpha of any stock, the person would most likely be concerned with which one of the following:
A. Risk-adjusted return
B. Internal rate of return
C. Price-to-earnings ratio
D. Sharpe ratio
Total risk refers to a combination of unsystematic risk and systematic risk, and standard deviation can be used to measure both risks. Unsystematic risks are diversifiable risks and can significantly be reduced by diversification. Market risk is not considered to be an unsystematic risk.
The first three risk types ate non-diversifiable or systematic risks. Unsystematic risks are also referred to as diversifiable risk.
When a bond matures it always pay off at par. The bond’s relationship with current interest rates or the difference with its coupon all don’t matter. When you buy corporate bonds you are exposed to call risk, inflation and credit risks.
Systematic risks refer to risks involving the entire market and they include interest rate, exchange rate risk, purchasing power risk, reinvestment risk and market risk. Unsystematic risks or diversifiable risk affect a single country, business, security or industry. Unsystematic risks can be curbed with diversification, but systematic risks are non-diversifiable risks.
Regulatory risk refers to the uncertainty of how changes in legislation at the local, state or federal level would affect expected rewards from securities purchased. When the federal government changes its tax policy on municipal bonds, investors may have to pay more as tax from any income generated from the security.
Liquidity describes the ability to convert assets to cash or its equivalent with minimal loss in value.
Risk-adjusted return measures the risks undergone to achieve desired returns. The stock alpha is the excess return above the return that was expected for the risk level implied by the stock’s beta. An alpha rating is assigned to the security to indicate the risk-adjusted return. The sharp ratio makes use of standard deviation to measure performance.
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