AIP Risk Assessment & Regulatory Compliance 3 — Questions and Answers
Question 1: A client complains that their broker churned their account to generate commissions. Under FINRA rules, which metric is most commonly used to assess whether excessive trading occurred?
- Sharpe ratio
- Turnover rate and cost-to-equity ratio (Correct answer)
- Beta relative to benchmark
- Maximum drawdown percentage
Correct answer: Turnover rate and cost-to-equity ratio
Churning analysis typically focuses on the turnover rate (how often the portfolio is turned over) and the cost-to-equity ratio (how much the account must earn just to break even on commissions).
Question 2: The Investment Company Act of 1940 requires registered investment companies to maintain what minimum percentage of liquid assets to meet redemptions under normal conditions?
- 5%
- 10%
- 15% (Correct answer)
- 25%
Correct answer: 15%
Under SEC Rule 22e-4 (the Liquidity Rule), registered open-end funds must maintain at least 15% of net assets in 'highly liquid investments' to meet anticipated redemptions.
Question 3: Which of the following is an example of 'model risk' in investment management?
- A portfolio manager failing to diversify across sectors
- A quantitative model producing incorrect valuations due to flawed assumptions (Correct answer)
- An adviser failing to disclose fees on Form ADV
- Market-wide losses from interest rate increases
Correct answer: A quantitative model producing incorrect valuations due to flawed assumptions
Model risk is the risk of loss resulting from using inaccurate or flawed financial models, including incorrect assumptions, data errors, or misapplication of the model.
Question 4: Under FINRA Rule 4511, member firms must preserve most books and records for a minimum of how many years?
- 2 years
- 3 years
- 6 years (Correct answer)
- 10 years
Correct answer: 6 years
FINRA Rule 4511 requires member firms to preserve most books and records for a minimum of six years, with the first two years in an easily accessible location.
Question 5: A fund manager implements a 'stop-loss' rule to sell any position that declines more than 10% from its peak. This is an example of which type of risk management technique?
- Hedging
- Diversification
- Position limit rule
- Loss mitigation / downside protection (Correct answer)
Correct answer: Loss mitigation / downside protection
A stop-loss rule is a loss mitigation technique that automatically limits downside by triggering a sale when losses reach a predefined threshold.
Question 6: The Dodd-Frank Act's Volcker Rule primarily restricts which type of activity for banking entities?
- Providing investment advice to retail clients
- Proprietary trading and certain relationships with hedge funds and private equity funds (Correct answer)
- Underwriting municipal securities
- Operating as a transfer agent for mutual funds
Correct answer: Proprietary trading and certain relationships with hedge funds and private equity funds
The Volcker Rule prohibits banking entities from engaging in proprietary trading and from owning, sponsoring, or having certain relationships with hedge funds and private equity funds.
Question 7: Which of the following scenarios best illustrates 'counterparty risk' in a derivatives transaction?
- A bond issuer misses an interest payment
- The interest rate benchmark used in a swap is discontinued
- The entity on the other side of an OTC swap defaults before settlement (Correct answer)
- A futures contract's underlying commodity price falls sharply
Correct answer: The entity on the other side of an OTC swap defaults before settlement
Counterparty risk in derivatives is the risk that the other party to an OTC contract will default on its obligation before or at settlement.
AIP Risk Assessment & Regulatory Compliance 3
A client complains that their broker churned their account to generate commissions.
Under FINRA rules, which metric is most commonly used to assess whether excessive trading occurred?