WMS Risk Assessment & Mitigation 2 — Questions and Answers
Question 1: A client's portfolio has a beta of 1.4. What does this indicate about the portfolio's systematic risk relative to the market?
- It moves 40% more than the market on average (Correct answer)
- It has 40% less volatility than the market
- It is 40% correlated with a benchmark
- It generates 40% more alpha than a passive index
Correct answer: It moves 40% more than the market on average
A beta of 1.4 means the portfolio is expected to move 40% more than the market in either direction, indicating higher systematic risk.
Question 2: Which risk mitigation technique involves transferring risk to a third party through an insurance contract or derivative instrument?
- Risk retention
- Risk avoidance
- Risk transfer (Correct answer)
- Risk reduction
Correct answer: Risk transfer
Risk transfer shifts financial exposure to another party, such as through insurance policies, options, or swap agreements.
Question 3: A wealth manager uses a Monte Carlo simulation to evaluate a client's retirement plan. What is the PRIMARY purpose of this tool in risk assessment?
- To calculate exact future portfolio values
- To model a range of probabilistic outcomes based on variable inputs (Correct answer)
- To identify the optimal asset allocation for maximum return
- To measure the portfolio's sensitivity to interest rate changes
Correct answer: To model a range of probabilistic outcomes based on variable inputs
Monte Carlo simulations run thousands of randomized scenarios to produce a probability distribution of possible outcomes, not a single forecast.
Question 4: When assessing a client's risk capacity, which factor is MOST relevant?
- The client's stated preference for aggressive investments
- The client's financial ability to absorb potential losses without compromising goals (Correct answer)
- The client's knowledge of financial markets
- The client's historical investment behavior
Correct answer: The client's financial ability to absorb potential losses without compromising goals
Risk capacity is an objective measure of how much loss a client can financially sustain while still meeting essential financial goals.
Question 5: A portfolio manager notices that two asset classes in a client's portfolio have a correlation coefficient of -0.85. How does this affect diversification?
- It provides little diversification benefit since the assets move together
- It significantly enhances diversification because the assets tend to move in opposite directions (Correct answer)
- It increases concentration risk within the portfolio
- It eliminates all systematic risk from the portfolio
Correct answer: It significantly enhances diversification because the assets tend to move in opposite directions
A correlation of -0.85 means the assets move strongly in opposite directions, which substantially reduces overall portfolio volatility through diversification.
Question 6: Which of the following best describes 'sequence of returns risk' in the context of retirement planning?
- The risk that returns will average below expected levels over a full market cycle
- The risk that poor early returns combined with withdrawals will deplete a portfolio before recovery (Correct answer)
- The risk that inflation will erode the purchasing power of fixed income
- The risk that a retiree will outlive their expected lifespan
Correct answer: The risk that poor early returns combined with withdrawals will deplete a portfolio before recovery
Sequence of returns risk is particularly damaging in the early withdrawal phase because poor early returns reduce the portfolio base that would otherwise recover.
Question 7: A wealth manager recommends rebalancing a client's portfolio from 70/30 equities/bonds back to the target 60/40 allocation. What risk is being primarily managed?
- Inflation risk
- Liquidity risk
- Drift risk leading to unintended risk exposure (Correct answer)
- Credit risk
Correct answer: Drift risk leading to unintended risk exposure
Rebalancing controls drift risk, which occurs when market movements cause the actual allocation to deviate from the intended risk profile.
WMS Risk Assessment & Mitigation 2
A client's portfolio has a beta of 1.4.
What does this indicate about the portfolio's systematic risk relative to the market?