Stock Broker Portfolio Analysis & Risk Management 1 — Questions and Answers
Question 1: What is 'diversification' in portfolio management and why is it considered beneficial?
- Investing all funds in the best-performing sector
- Spreading investments across different asset classes, sectors, and geographies to reduce unsystematic risk (Correct answer)
- Using leverage to amplify returns
- Concentrating in one company with the strongest balance sheet
Correct answer: Spreading investments across different asset classes, sectors, and geographies to reduce unsystematic risk
Diversification involves spreading investments across various asset classes, sectors, and regions so that poor performance in one area is offset by others, reducing unsystematic (company-specific) risk without necessarily sacrificing expected returns.
Question 2: What is 'beta' as a measure of risk in securities analysis?
- A measure of a company's profitability relative to peers
- A measure of a security's price volatility relative to the overall market (Correct answer)
- The interest rate sensitivity of a bond
- The probability of a company defaulting on its debt
Correct answer: A measure of a security's price volatility relative to the overall market
Beta measures the sensitivity of a security's price movements relative to the broader market; a beta of 1 moves with the market, above 1 is more volatile, and below 1 is less volatile.
Question 3: What is 'alpha' in the context of investment performance evaluation?
- The risk-free rate of return
- The excess return of an investment relative to its expected return given its risk (beta) (Correct answer)
- The total return including dividends
- The annualized volatility of a portfolio
Correct answer: The excess return of an investment relative to its expected return given its risk (beta)
Alpha represents the excess return a portfolio or security generates above what would be predicted by its beta (systematic risk exposure), measuring the value added by the investment manager's skill.
Question 4: What is the 'Sharpe ratio' and what does it measure?
- A ratio of a company's earnings to its share price
- A measure of risk-adjusted return, calculated as excess return above the risk-free rate divided by standard deviation (Correct answer)
- The ratio of a bond's duration to its yield
- The percentage of gains retained after taxes
Correct answer: A measure of risk-adjusted return, calculated as excess return above the risk-free rate divided by standard deviation
The Sharpe ratio measures risk-adjusted performance by dividing a portfolio's excess return (above the risk-free rate) by its standard deviation, showing how much return is earned per unit of total risk taken.
Question 5: What is 'duration' as it relates to bond price sensitivity?
- The number of years until a bond matures
- A measure of a bond's sensitivity to interest rate changes; longer duration means greater price sensitivity (Correct answer)
- The frequency of coupon payments
- The credit rating period of a bond
Correct answer: A measure of a bond's sensitivity to interest rate changes; longer duration means greater price sensitivity
Duration measures how sensitive a bond's price is to changes in interest rates; a bond with a duration of 5 years will fall approximately 5% in price for each 1% rise in interest rates.
Question 6: What is 'systematic risk' (also called market risk) versus 'unsystematic risk' (also called idiosyncratic risk)?
- Systematic = company risk; unsystematic = industry risk
- Systematic = broad market risk that affects all investments and cannot be diversified away; unsystematic = company-specific risk that can be reduced through diversification (Correct answer)
- Systematic = interest rate risk; unsystematic = credit risk
- Systematic = short-term risk; unsystematic = long-term risk
Correct answer: Systematic = broad market risk that affects all investments and cannot be diversified away; unsystematic = company-specific risk that can be reduced through diversification
Systematic risk affects the entire market (recessions, inflation, geopolitical events) and cannot be eliminated through diversification; unsystematic risk is specific to a company or industry and can be reduced by holding a diversified portfolio.
Stock Broker Portfolio Analysis & Risk Management 1
What is 'diversification' in portfolio management and why is it considered beneficial?