IAR Risk Assessment & Management 4 — Questions and Answers
Question 1: Value at Risk (VaR) at the 95% confidence level over one month states that:
- The portfolio will lose exactly that amount each month
- Losses will exceed that amount in 5% of months (Correct answer)
- The portfolio will gain at least that amount 95% of the time
- The maximum possible loss is limited to that amount
Correct answer: Losses will exceed that amount in 5% of months
VaR at 95% confidence means there is a 5% probability that losses will exceed the stated amount over the given time period.
Question 2: Which of the following scenarios represents reinvestment risk?
- A bond issuer files for bankruptcy before maturity
- Interest rates fall and coupon payments must be reinvested at lower rates (Correct answer)
- Inflation rises faster than the bond's coupon rate
- The bond cannot be sold without a significant price discount
Correct answer: Interest rates fall and coupon payments must be reinvested at lower rates
Reinvestment risk is the possibility that cash flows from a bond will be reinvested at a lower rate than the original yield, reducing total return.
Question 3: A client's risk questionnaire reveals high willingness to take risk but low financial capacity. The IAR should:
- Default to the client's stated willingness and invest aggressively
- Use the more conservative of the two measures to guide the portfolio (Correct answer)
- Defer entirely to the client's emotional preference
- Construct two separate portfolios based on each measure
Correct answer: Use the more conservative of the two measures to guide the portfolio
When willingness and ability to bear risk conflict, the more conservative measure should govern the portfolio construction to protect the client from financial harm.
Question 4: A hedge fund uses a long-short equity strategy. The primary risk management benefit of the short positions is:
- Increasing leverage in rising markets
- Reducing net market exposure and hedging against broad market declines (Correct answer)
- Eliminating credit risk in the portfolio
- Providing guaranteed downside protection
Correct answer: Reducing net market exposure and hedging against broad market declines
Short positions offset some of the long exposure, reducing the portfolio's net market risk and providing a partial hedge against broad equity market declines.
Question 5: Tactical asset allocation differs from strategic asset allocation in that it:
- Sets a permanent target mix based on long-term goals
- Makes short-term deviations from the target to exploit market opportunities (Correct answer)
- Eliminates the need for rebalancing
- Focuses exclusively on fixed-income securities
Correct answer: Makes short-term deviations from the target to exploit market opportunities
Tactical asset allocation temporarily shifts the portfolio away from its strategic targets to take advantage of perceived short-term market mispricings or economic conditions.
Question 6: A client has a significant allocation to emerging market equities. Which additional risk, beyond market risk, is most relevant?
- Reinvestment risk
- Currency and political risk (Correct answer)
- Call risk
- Prepayment risk
Correct answer: Currency and political risk
Emerging market investments carry elevated currency risk from exchange rate fluctuations and political risk from less stable regulatory and governmental environments.
Question 7: An IAR uses a 'bucket strategy' for a retiree client. What primary risk does this strategy address?
- Inflation risk
- Sequence-of-returns risk by holding short-term liquid assets separately (Correct answer)
- Credit risk in the bond portfolio
- Currency risk from international holdings
Correct answer: Sequence-of-returns risk by holding short-term liquid assets separately
The bucket strategy segregates assets by time horizon so that near-term withdrawals are funded from cash or short-term assets, insulating the portfolio from being forced to sell equities at depressed prices.
IAR Risk Assessment & Management 4
Value at Risk (VaR) at the 95% confidence level over one month states that: