CISI IoI Investment Risk and Return 2 — Questions and Answers
Question 1: What is 'market risk' (also called systematic risk)?
- The risk specific to a single company, such as management failure
- The risk inherent to the entire market that cannot be eliminated through diversification, such as recessions or interest rate changes (Correct answer)
- The risk of a stock exchange experiencing technical failures
- The risk that a market regulator changes the rules governing trading
Correct answer: The risk inherent to the entire market that cannot be eliminated through diversification, such as recessions or interest rate changes
Systematic (market) risk affects the whole market and cannot be diversified away. Examples include macroeconomic shocks, interest rate changes, and recessions. In contrast, unsystematic (specific) risk relates to individual companies and can be reduced through diversification.
Question 2: What is the relationship between risk and time horizon in investing?
- Risk does not change with time horizon
- Longer time horizons generally reduce risk because short-term volatility smooths out over time, and investors have more time to recover from market downturns (Correct answer)
- Short-term investors should always take higher risk
- Risk increases proportionally with the length of the investment horizon
Correct answer: Longer time horizons generally reduce risk because short-term volatility smooths out over time, and investors have more time to recover from market downturns
Over longer time periods, markets have historically recovered from downturns. Investors with a long time horizon can afford to hold higher-risk assets, knowing they have time to wait for recoveries. Short-term investors cannot afford significant capital loss.
Question 3: What is 'currency risk'?
- The risk that a country changes its currency to a new denomination
- The risk that changes in exchange rates reduce the value of foreign investments when converted back to the investor's home currency (Correct answer)
- The risk that a currency becomes illiquid and cannot be exchanged
- The risk that transaction costs on currency exchange erode all investment gains
Correct answer: The risk that changes in exchange rates reduce the value of foreign investments when converted back to the investor's home currency
Currency risk affects investors holding foreign-denominated assets. If the foreign currency weakens against sterling, the value of the investment when converted back to GBP falls, even if the investment has performed well in local currency terms.
Question 4: What is 'counterparty risk'?
- The risk that a competitor enters the same market
- The risk that the other party to a financial contract defaults on their obligations (Correct answer)
- The risk that a regulator imposes new rules on a transaction
- The risk that market prices move against the investor's position
Correct answer: The risk that the other party to a financial contract defaults on their obligations
Counterparty risk is the risk that the person or institution on the other side of a financial transaction (a counterparty) fails to meet their contractual obligation. It is particularly relevant in derivatives and over-the-counter (OTC) transactions.
Question 5: What does a 'risk profile questionnaire' assess?
- The client's knowledge of financial markets
- The client's attitude to risk, capacity for loss, and time horizon, helping to determine the appropriate level of investment risk (Correct answer)
- The client's tax liabilities and reliefs
- The client's existing investment portfolio and its performance
Correct answer: The client's attitude to risk, capacity for loss, and time horizon, helping to determine the appropriate level of investment risk
A risk profile questionnaire gathers information about a client's attitude to investment risk (how they feel about potential losses), their capacity for loss (how much they could afford to lose without hardship), and their time horizon, enabling the adviser to recommend suitably matched investments.
Question 6: What is 'concentration risk'?
- The risk that too many investors buy the same fund simultaneously
- The risk of having too large a proportion of a portfolio in a single investment, sector, or asset class, so that poor performance in that area has a disproportionate impact (Correct answer)
- The risk that an investment manager concentrates on too few investments
- The risk that all global markets fall simultaneously
Correct answer: The risk of having too large a proportion of a portfolio in a single investment, sector, or asset class, so that poor performance in that area has a disproportionate impact
Concentration risk arises when a portfolio is overly weighted towards a single stock, sector, geography, or asset class. Poor performance in that concentrated area will have a disproportionately large negative impact on the overall portfolio.
CISI IoI Investment Risk and Return 2
What is 'market risk' (also called systematic risk)?