IMC Asset Classes 4 — Questions and Answers
Question 1: What is 'credit risk' in the context of bond investing?
- The risk that interest rates will change
- The risk that the bond issuer will default on interest or principal payments (Correct answer)
- The risk of inflation eroding returns
- The risk of currency movements
Correct answer: The risk that the bond issuer will default on interest or principal payments
Credit risk (default risk) is the risk that the bond issuer will be unable to make scheduled interest payments or repay principal at maturity. Higher credit risk bonds (high yield/junk bonds) offer higher yields to compensate investors.
Question 2: What is the 'equity risk premium' (ERP)?
- The fee charged by equity fund managers
- The additional return investors expect from equities over the risk-free rate, as compensation for higher risk (Correct answer)
- The dividend yield of equity indices
- The volatility of equity markets
Correct answer: The additional return investors expect from equities over the risk-free rate, as compensation for higher risk
The equity risk premium is the excess return that investing in the stock market is expected to provide over a risk-free rate (such as gilts). It compensates investors for accepting the additional volatility and risk of equities versus 'safe' government bonds.
Question 3: What is a 'real return' on an investment?
- The return before fees and charges
- The return adjusted for inflation (Correct answer)
- The return on property investments
- The return on index-linked gilts only
Correct answer: The return adjusted for inflation
Real return is the nominal (stated) return adjusted for inflation. If an investment returns 6% nominally but inflation is 3%, the real return is approximately 3%. Real returns reflect the actual increase in purchasing power.
Question 4: What is 'currency risk' in international investing?
- The risk of counterfeit currency
- The risk that exchange rate movements will reduce returns when investing in foreign assets (Correct answer)
- The risk of transaction costs on currency exchange
- The risk that a currency is devalued by government action only
Correct answer: The risk that exchange rate movements will reduce returns when investing in foreign assets
Currency risk arises when investing in assets denominated in foreign currencies. If sterling strengthens against the investment's currency, the sterling value of returns falls even if the underlying investment performs well.
Question 5: What is a 'real asset'?
- A financial asset with a guaranteed return
- A tangible physical asset such as property, infrastructure, or commodities that typically provides a hedge against inflation (Correct answer)
- Any asset held in the UK
- An asset that has been independently valued
Correct answer: A tangible physical asset such as property, infrastructure, or commodities that typically provides a hedge against inflation
Real assets are tangible physical assets with intrinsic value — including real estate, infrastructure, commodities, and timberland. They often provide inflation-linked returns, as their values and income streams tend to rise with inflation.
Question 6: What does 'correlation' mean in portfolio construction?
- The size of an investment relative to the portfolio
- A statistical measure of how two assets move in relation to each other, ranging from -1 to +1 (Correct answer)
- The fee charged for correlated assets
- The credit rating relationship between issuers
Correct answer: A statistical measure of how two assets move in relation to each other, ranging from -1 to +1
Correlation measures the degree to which two assets move together. A correlation of +1 means perfect positive correlation (move identically), -1 means perfect inverse correlation, and 0 means no relationship. Low correlation between assets improves diversification.
IMC Asset Classes 4
What is 'credit risk' in the context of bond investing?