WMS Risk Assessment & Mitigation 3 — Questions and Answers
Question 1: What does a Value at Risk (VaR) figure of $50,000 at a 95% confidence level over one month mean?
- The portfolio will lose exactly $50,000 in the worst 5% of months
- There is a 5% chance the portfolio will lose more than $50,000 in a given month (Correct answer)
- The portfolio is guaranteed to lose no more than $50,000 in any month
- The expected monthly loss is $50,000 on average
Correct answer: There is a 5% chance the portfolio will lose more than $50,000 in a given month
VaR at 95% confidence means there is a 5% probability that losses will exceed the stated amount over the specified period.
Question 2: A client holds a concentrated position representing 60% of their net worth in a single employer stock. Which risk is MOST acute?
- Market risk only
- Idiosyncratic risk due to lack of diversification (Correct answer)
- Interest rate risk
- Currency risk
Correct answer: Idiosyncratic risk due to lack of diversification
Idiosyncratic (unsystematic) risk is the company-specific risk that cannot be diversified away and is amplified by a concentrated single-stock position.
Question 3: Which hedging strategy would BEST protect a client with a large unrealized gain in a single stock from downside risk while deferring capital gains taxes?
- Selling covered calls against the position
- Purchasing protective put options on the stock (Correct answer)
- Shorting the stock in a margin account
- Exchanging the stock for shares in an ETF
Correct answer: Purchasing protective put options on the stock
Protective puts provide downside protection without triggering a taxable sale event, preserving the position while hedging the risk.
Question 4: In risk profiling, what is the distinction between risk tolerance and risk aversion?
- Risk tolerance is objective while risk aversion is purely emotional
- Risk tolerance is the level of risk a client accepts willingly; risk aversion describes the degree to which they dislike uncertainty (Correct answer)
- Risk aversion applies only to bond investors while risk tolerance applies to equity investors
- They are interchangeable terms describing the same behavioral trait
Correct answer: Risk tolerance is the level of risk a client accepts willingly; risk aversion describes the degree to which they dislike uncertainty
Risk tolerance is the client's willingness to accept risk for potential reward, while risk aversion quantifies their psychological discomfort with uncertainty and potential loss.
Question 5: A corporate bond rated BB is downgraded to B. What type of risk has materialized for the bondholder?
- Interest rate risk
- Reinvestment risk
- Credit migration risk (Correct answer)
- Liquidity risk
Correct answer: Credit migration risk
Credit migration risk is the risk that a bond's credit rating will be downgraded, resulting in a higher required yield and lower market price.
Question 6: Which risk mitigation approach involves deliberately spreading investments across uncorrelated geographic regions to reduce exposure to a single economy?
- Tactical asset allocation
- International diversification (Correct answer)
- Sector rotation
- Currency hedging
Correct answer: International diversification
International diversification reduces country-specific and regional economic risks by allocating capital across multiple geographic markets with lower return correlations.
Question 7: A wealth manager conducts a stress test by simulating a 2008-style financial crisis on a client's portfolio. What is the PRIMARY limitation of historical stress testing?
- It uses overly complex mathematical models
- Past crisis scenarios may not capture the magnitude or nature of future crises (Correct answer)
- It only works for equity-heavy portfolios
- It requires daily price data unavailable for most assets
Correct answer: Past crisis scenarios may not capture the magnitude or nature of future crises
Historical stress tests are backward-looking and assume future crises will resemble past ones, potentially missing novel risk factors or unprecedented market dislocations.
WMS Risk Assessment & Mitigation 3
What does a Value at Risk (VaR) figure of $50,000 at a 95% confidence level over one month mean?