Chapter 5 Practice Question Answers
- 1. Answer: D. Interest rate risk refers to the risk of fluctuation in the market value of fixed income securities due to interest rate movements. Interest rate risk is generally higher for fixed income investments with longer maturities and higher durations.
- 2. Answer: C. Interest rate risk refers to the risk that interest rates will increase, causing the value of your bond to decrease. The probability of interest rates rising during longer time spans is greater than shorter time spans; hence, the 30-year Treasury bond has greater interest rate risk than any of the other bonds.
- 3. Answer: D. Unsystematic risk is the risk that a single stock performs poorly independent of reasons that impact the overall market. To avoid unsystematic risk, Hailey should invest in a diversified portfolio of many stocks. Of the choices listed, the mutual fund is most likely to provide such diversification, as these funds typically have a large number of stock holdings. The other choices have too few holdings to provide such diversification.
- 4. Answer: B. Diversifying a stock portfolio involves having many stock holdings with different characteristics, such as industry and market cap size. Unsystematic risk is the risk that any one particular investment could lose value. Diversification reduces unsystematic risk. Diversification does not affect systematic risk, also called market risk, which is the risk that the entire market could decline.
- 5. Answer: D. Systematic risk applies to an entire market or asset class and is generally considered inherent to that group and is not remedied by diversification. Unsystematic risk applies to a specific investment or company and can be remedied through diversification. For example, all bonds are subject to interest rate risk, which is a systematic risk. A newspaper publisher, on the other hand, is subject to the business risk that newspapers may become obsolete as a result of the Inter