CFP Risk Assessment & Management 3 — Questions and Answers
Question 1: The Sharpe ratio is used to measure which of the following?
- Total portfolio risk relative to benchmark
- Risk-adjusted return per unit of total risk (Correct answer)
- The correlation between a portfolio and the market
- The portfolio's sensitivity to interest rate changes
Correct answer: Risk-adjusted return per unit of total risk
The Sharpe ratio measures excess return (above the risk-free rate) per unit of total risk (standard deviation), allowing comparison of risk-adjusted performance.
Question 2: A 65-year-old retiree is concerned about outliving her savings. Which type of risk is she MOST concerned about?
- Market risk
- Liquidity risk
- Longevity risk (Correct answer)
- Credit risk
Correct answer: Longevity risk
Longevity risk is the risk of outliving one's financial resources, a primary concern for retirees who may live longer than anticipated.
Question 3: A client holds a large concentration in their employer's stock. The MOST appropriate risk management strategy is to:
- Immediately sell all shares to eliminate risk
- Diversify by gradually selling shares and reinvesting in a diversified portfolio (Correct answer)
- Hold the stock because employer stock always outperforms the market
- Increase the concentration to maximize potential gains
Correct answer: Diversify by gradually selling shares and reinvesting in a diversified portfolio
Gradually diversifying away from concentrated employer stock reduces company-specific risk while managing tax implications from large taxable gains.
Question 4: Which of the following BEST describes reinvestment risk?
- The risk that a bond issuer will default on interest payments
- The risk that cash flows will be reinvested at a lower rate than the original investment (Correct answer)
- The risk that rising interest rates will reduce a bond's market value
- The risk that a bond cannot be sold quickly at a fair price
Correct answer: The risk that cash flows will be reinvested at a lower rate than the original investment
Reinvestment risk is the risk that future cash flows, such as coupon payments, will be reinvested at lower interest rates than the original investment earned.
Question 5: Which risk management technique involves transferring risk to a third party?
- Risk retention
- Risk avoidance
- Risk transfer (Correct answer)
- Risk reduction
Correct answer: Risk transfer
Risk transfer shifts the financial burden of a risk to another party, most commonly through purchasing insurance or using hedging instruments like derivatives.
Question 6: Standard deviation as a measure of risk is MOST useful when comparing investments that:
- Have different expected returns and different asset classes
- Are normally distributed and of similar types (Correct answer)
- Have negative correlation with each other
- Are illiquid and hold alternative assets
Correct answer: Are normally distributed and of similar types
Standard deviation is most meaningful when comparing investments with similar return distributions (approximately normal) and of comparable asset classes.
Question 7: A client has significant human capital remaining (many working years ahead). How should this affect their investment portfolio risk level?
- They should hold less equity because human capital is risky
- Human capital acts like a bond, so they can hold more equity in their financial portfolio (Correct answer)
- Human capital has no relevance to portfolio construction decisions
- They should avoid equities entirely to preserve human capital value
Correct answer: Human capital acts like a bond, so they can hold more equity in their financial portfolio
Human capital (future earnings) often resembles a bond-like asset, so investors with high human capital can afford to hold more equity in their financial portfolio for total balance.
CFP Risk Assessment & Management 3
The Sharpe ratio is used to measure which of the following?