Identify Investment Risk Types - Securities Industry Essentials SIE

1. What is political risk, and which investments are most exposed to it?

   Risk political instability harms value; common in foreign investments. Instability such as government changes or geopolitical events can lead to asset expropriation or value erosion, particularly in emerging markets.

2. What is currency (exchange rate) risk for a United States investor in foreign securities?

   Risk foreign currency falls versus the dollar, reducing returns. Depreciation of the foreign currency against the USD reduces the converted value of dividends, interest, or capital gains when repatriated.

3. What is default risk as it applies to bonds and other debt securities?

   Risk the issuer fails to pay interest and or principal. It represents the possibility that the bond issuer will be unable to meet contractual obligations for timely interest and principal repayments.

4. What is reinvestment risk for a bond investor receiving coupon payments?

   Risk coupons are reinvested at lower rates than expected. Falling interest rates may force investors to reinvest periodic coupon payments at lower yields, reducing the overall return compared to initial expectations.

5. Identify the bond feature that reduces call risk compared with a callable bond.

   Noncallable structure or strong call protection. These features prevent or delay early redemption by the issuer, allowing investors to retain higher-yielding bonds longer.

6. What is call risk for a callable bond investor?

   Risk issuer redeems early, limiting upside and forcing reinvestment. Issuers may redeem callable bonds when rates fall to refinance cheaply, capping investor gains and requiring reinvestment at lower prevailing rates.

7. What is inflation (purchasing power) risk for an investor?

   Risk inflation erodes real returns and future purchasing power. Rising prices diminish the real value of nominal returns, reducing the investor's ability to purchase goods and services in the future.

8. What is unsystematic (nonmarket) risk, and what is its primary source?

   Issuer-specific risk tied to a company or industry. It originates from factors unique to a particular company or sector, such as management decisions or industry-specific events, which can be mitigated by diversification.

9. What is prepayment risk, and which securities are most associated with it?

   Risk principal returns early; common in MBS. Early principal repayment, often in mortgage-backed securities when rates drop, forces investors to reinvest at lower yields sooner than anticipated.

10. What is concentration risk in portfolio construction?

    Risk from overexposure to one issuer, sector, asset class, or region. Overconcentration amplifies the impact of adverse events in the focused area, increasing overall portfolio volatility.

11. Which mitigation strategy best addresses unsystematic risk: diversification or hedging?

    Diversification. Diversification spreads investments across uncorrelated assets, minimizing the effects of issuer-specific or sector-specific risks.

12. What is credit risk in fixed income, and what two components make it up?

    Default risk and credit spread risk. In fixed-income securities, it encompasses the potential for issuer default on payments and fluctuations in yield spreads due to changes in perceived creditworthiness.

13. Which risk type is reduced most directly through diversification across many issuers?

    Unsystematic (issuer-specific) risk. Diversification spreads investments across multiple issuers, reducing the impact of adverse events affecting any single security or sector.

14. Which investment type is commonly used to mitigate inflation risk in fixed income?

    Treasury Inflation-Protected Securities (TIPS). TIPS adjust principal and interest payments in line with inflation metrics, preserving the real value of returns.

15. What is business risk for a common stock investor?

    Risk earnings and cash flow decline due to operations and competition. Operational inefficiencies, competitive pressures, or market changes can lead to reduced profitability, impacting stock valuations.

16. What is credit spread risk for a corporate or municipal bond holder?

    Risk spreads widen, lowering the bond price. Widening spreads reflect increased perceived risk over benchmark Treasuries, causing the bond's yield to rise and its market price to decline.

17. What is the most direct mitigation technique for currency risk in foreign investing?

    Currency hedging (for example, hedged funds or forward contracts). Hedging tools lock in exchange rates, protecting against adverse currency movements and stabilizing dollar-denominated returns.

18. What is interest rate risk, and which fixed-income prices does it primarily affect?

    Risk that rate changes move bond prices, mainly long maturities. Changes in prevailing interest rates cause inverse price movements in bonds, with longer-term securities exhibiting greater price volatility due to their higher duration.

19. What is extension risk for a bond investor, and when is it most likely?

    Risk maturity effectively lengthens when rates rise or prepay slows. In securities like MBS, rising rates slow prepayments, prolonging the bond's effective duration and increasing exposure to interest rate fluctuations.

20. Which liquidity-focused choice generally reduces liquidity risk: small-cap OTC or large-cap exchange-listed?

    Large-cap exchange-listed securities. Large-cap stocks on major exchanges typically offer higher trading volumes and tighter spreads, enabling quicker sales at fair prices.

21. What is market risk (systematic risk) in the context of securities investing?

    Risk from broad market movements affecting most securities. This risk stems from macroeconomic factors like recessions or interest rate changes that impact the entire market uniformly and cannot be eliminated through diversification.

22. What is regulatory or legislative risk for an issuer or an industry?

    Risk laws and regulations change, reducing profitability or value. New laws or regulations can increase costs, restrict operations, or alter competitive landscapes, thereby diminishing issuer or industry value.

23. Which mitigation strategy most directly reduces interest rate risk in a bond portfolio?

    Shorten duration by using shorter maturities. Shorter-duration bonds exhibit less price sensitivity to interest rate changes, thereby limiting potential capital losses.

24. What is liquidity risk in the secondary market for securities?

    Risk of not selling quickly without a significant price concession. In illiquid markets, sellers may need to accept lower prices to execute trades quickly, leading to potential losses.

25. Identify the relationship between interest rates and existing bond prices.

    Inverse relationship: rates up, bond prices down. Rising interest rates decrease the market value of existing bonds to align their yields with new, higher-yielding issuances.

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