Types of Risk

B is correct. Systematic risk (also called market risk or non-diversifiable risk) affects the entire market or economy and cannot be eliminated through diversification. This includes risks like inflation, interest rate changes, and overall market movements that impact all securities.

A (Business risk), C (Credit risk), and D (Liquidity risk) are all unsystematic risks that can be reduced or eliminated through diversification. By holding 15-20 different securities across various companies and industries, investors can minimize exposure to company-specific or industry-specific risks.

A is correct. A beta of 1.5 means the stock is expected to be 50% more volatile than the market. If the market moves up 10%, this stock would typically move up 15% (50% more). Beta measures systematic risk relative to the market, where the market has a beta of 1.0.

C (1.5 times as volatile) is incorrect because this would describe the total magnitude, not the relative difference. The correct interpretation is 50% more volatile, not 150% as volatile. A common exam trap is confusing "1.5 times" with "50% more." They're mathematically related but conceptually different. B and D are incorrect as they misinterpret how beta values work. Beta of 1.5 indicates greater volatility than the market, not less or equal.

B is correct. Interest rate risk is the risk that bond prices will fall when interest rates rise. Since this investor's bond was purchased when rates were lower, rising rates will cause the bond's market value to decline due to the inverse relationship between bond prices and interest rates. Longer maturity bonds like this 20-year Treasury have more interest rate risk.

A (Credit risk) is incorrect because Treasury securities have virtually no default risk. C (Reinvestment risk) is incorrect because that's the opposite risk. It occurs when rates fall and coupon payments must be reinvested at lower rates. D (Call risk) is incorrect because Treasury bonds are not callable.

D is correct. High-yield corporate bonds (also called junk bonds) have the highest credit risk because they are issued by companies with lower credit ratings and greater financial uncertainty. These bonds pay higher yields to compensate investors for the increased risk of default.

A (Treasury bonds) is incorrect because U.S. government securities are considered to have zero default risk. B (AAA-rated corporate bonds) is incorrect because these have the highest investment-grade rating and very low default risk. C (Investment-grade municipal bonds) is incorrect because these also have low default risk, though higher than Treasuries.

B is correct. Purchasing power risk (inflation risk) is the greatest concern for someone on a fixed income because inflation erodes the real value of their fixed payments over time. If their pension pays the same dollar amount each year, but costs rise due to inflation, they can buy less with their income.

A (Market risk) is incorrect because while relevant for investments, it doesn't directly address the erosion of fixed income purchasing power. C (Business risk) is incorrect because this is company-specific risk that doesn't apply to pension income. D (Currency risk) is incorrect because this only affects foreign investments and isn't the primary concern for domestic fixed-income recipients.

B is correct. Standard deviation measures total risk, including both systematic and unsystematic risk. It quantifies how much returns vary from the average, with higher standard deviation indicating more volatility and risk.

A (Beta) is incorrect because beta only measures systematic risk (market risk), not total risk. C (Alpha) is incorrect because alpha measures excess return compared to a benchmark, not risk. D (R-squared) is incorrect because it measures how closely a portfolio's movements correlate with a benchmark, not the amount of risk.

C is correct. Call risk is the risk that the issuer will redeem (call) the bond early when interest rates fall. Issuers call bonds to refinance at lower rates, leaving investors to reinvest their returned principal at the new, lower prevailing rates. This is most likely to occur in a declining interest rate environment.

A (Default risk) is incorrect because falling rates don't increase default probability. B (Extension risk) is incorrect because this is the opposite. It occurs when rates rise and prepayments slow. D (Interest rate risk) is incorrect because falling rates increase bond prices, which benefits the holder. However, the call feature prevents them from fully capturing this gain.

A is correct. Zero-coupon bonds have no reinvestment risk because they make no periodic interest payments (coupons) that need to be reinvested. The investor receives a single payment at maturity, eliminating the risk of having to reinvest coupon payments at lower interest rates.

B (High-coupon corporate bonds), C (Treasury notes), and D (Municipal bonds) all incorrect because they pay periodic interest that must be reinvested. This creates reinvestment risk, which is the risk that when interest rates fall, the coupon payments will have to be reinvested at lower rates than originally anticipated.

D is correct. Business risk (operational uncertainty, poor management, competitive pressures) and financial risk (excessive debt/leverage) are both unsystematic risks. They are specific to individual companies or industries and can be reduced through diversification.

A (Systematic risk), B (Market risk), and C (Non-diversifiable risk) are all incorrect because they refer to the same concept: risks that affect the entire market and cannot be diversified away. Business and financial risks are company-specific problems that can be mitigated by holding a diversified portfolio of securities.

C is correct. Research shows that holding approximately 15-20 securities can eliminate most unsystematic risk (company-specific and industry-specific risk) from a portfolio. Beyond this number, additional diversification provides diminishing benefits for risk reduction.

A (Systematic risk), B (Interest rate risk), and D (Market risk) are all incorrect because these are systematic risks that affect the entire market and cannot be eliminated through diversification, no matter how many securities you hold. A well-diversified portfolio still faces these market-wide risks, which is why investors receive a risk premium for bearing them.