Differentiate Investment Risks - Series 65

1. What is the term for the portion of total risk that diversification cannot eliminate?

   Systematic (nondiversifiable) risk. This component reflects broad market movements that impact all investments similarly, unaffected by portfolio composition.

2. What is the term for the portion of total risk that diversification can largely eliminate?

   Unsystematic (diversifiable) risk. This component involves company-specific events that average out in a diversified portfolio.

3. State the CAPM expected return formula for a security using beta ($\beta$).

   $E(R_i)=R_f+\beta_i\left(E(R_m)-R_f\right)$. CAPM posits that expected return compensates for time value and systematic risk premium scaled by beta.

4. Identify the risk type: a company-specific accounting scandal causes one stock to fall.

   Unsystematic risk. Company-specific events impact only that stock, allowing diversification to mitigate such isolated risks.

5. If a stock has $\beta=1.5$, how does its systematic risk compare to the market?

   About $1.5\times$ the market's systematic risk. Beta measures volatility relative to the market, so 1.5 implies amplified responses to market changes.

6. All else equal, how does increasing financial leverage tend to affect a firm's equity beta ($\beta$)?

   It increases equity $\beta$. Leverage magnifies the impact of operating risk on equity, raising sensitivity to market movements.

7. What is systematic risk (market risk) in an investment context?

   Risk affecting most securities; cannot be diversified away. It arises from economy-wide factors like interest rates or recessions that impact the entire market uniformly.

8. Identify the risk type: a sudden economy-wide recession reduces most stock prices.

   Systematic risk. Economy-wide events like recessions affect the broad market, representing non-diversifiable exposure.

9. What is capital structure?

   The mix of debt and equity used to finance a firm. Capital structure determines financing costs and risk allocation between debt holders and equity investors.

10. Which type of risk is reduced primarily through diversification: systematic or unsystematic?

    Unsystematic risk. Diversification spreads investments across assets, canceling out idiosyncratic risks but not market-wide fluctuations.

11. What is the key reason debt increases risk to common shareholders?

    Debt has priority claims; equity bears residual cash flow risk. Debt requires fixed payments, leaving equity holders with more variable residual claims on cash flows.

12. What is unsystematic risk (idiosyncratic risk) in an investment context?

    Security/issuer-specific risk; diversifiable with a portfolio. It stems from factors unique to a particular company or industry, which can be mitigated by holding a variety of assets.

13. What is the key distinction between business risk and financial risk for a firm?

    Business: operating uncertainty; Financial: added risk from leverage. Business risk reflects inherent operational volatility, while financial risk overlays additional uncertainty from debt financing.

14. All else equal, how does increasing debt in capital structure affect equity risk?

    It increases equity risk (greater earnings/price volatility). Higher debt amplifies returns in good times but magnifies losses in bad, increasing shareholder volatility.

15. Identify the risk type: a highly leveraged firm faces higher probability of bankruptcy in a downturn.

    Financial (leverage) risk. High debt levels amplify downturn impacts by increasing fixed obligations, elevating bankruptcy likelihood.

16. What is business risk in relation to systematic vs. unsystematic risk?

    Primarily unsystematic; tied to operations and industry factors. Business risk involves variability in operating income due to firm-specific and sector factors, which diversification can reduce.

17. If a stock has $\beta=1.0$, what does that imply about its systematic risk vs. the market?

    Market-average systematic risk. A beta of 1 indicates the stock moves in line with the market, sharing identical exposure to systematic factors.

18. Which risk type is most closely captured by beta ($\beta$) in the CAPM framework?

    Systematic risk. Beta quantifies a security's sensitivity to market movements, representing exposure to non-diversifiable factors.

19. What is the definition of default risk in capital structure terms?

    Risk the issuer cannot meet debt service (interest/principal) obligations. Default risk arises when leverage creates fixed obligations that may exceed cash flows during downturns.

20. Which has higher claim priority in liquidation: secured debt or common stock?

    Secured debt. In liquidation, secured debt is backed by collateral, granting it seniority over unsecured claims like equity.

21. Which has higher claim priority in liquidation: preferred stock or common stock?

    Preferred stock. Preferred stock has a higher position in the capital structure, entitling it to assets before common stockholders.

22. If a stock has $\beta=0.5$, how does its systematic risk compare to the market?

    About $0.5\times$ the market's systematic risk. Beta below 1 signifies lower sensitivity to market swings, reducing exposure to systematic volatility.

23. What is the primary capital structure implication of adding preferred stock vs. adding debt?

    Preferred adds fixed-like payouts without contractual default like debt. Preferred stock introduces quasi-fixed dividends, increasing equity risk without the legal enforcement of debt obligations.

24. What is financial (leverage) risk in relation to capital structure?

    Risk added by debt and fixed obligations in the capital structure. Leverage amplifies earnings volatility by introducing fixed interest costs that must be paid regardless of profits.

25. Which type of risk remains even in a well-diversified portfolio?

    Systematic risk. Even with diversification, economy-wide events affect all securities, leaving this inherent market exposure.

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