Chapter 14: Risks & Disclosures

Question 1

________ Risk:
This the risk in the return of an investment that is associated with the macroeconomic factors that affect all risky assets.

Answer 1

Systematic Risk

Stated another way, systematic risk is the risk that changes in the overall economy will have an adverse effect on individual securities regardless of the company’s circumstances.

Question 2

________ Risk:
Systematic risk is generally caused by factors that affect all businesses, such as war, global security threats, or inflation.

Answer 2

Systematic Risk

Stated another way, systematic risk is the risk that changes in the overall economy will have an adverse effect on individual securities regardless of the company’s circumstances.

Question 3

________ Risk:
Primary examples include;market risk, interest rate risk, and purchasing power risk. Also referred to as nondiversifiable risk because, it cannot be reduced through diversification.

Answer 3

Systematic Risk

Stated another way, systematic risk is the risk that changes in the overall economy will have an adverse effect on individual securities regardless of the company’s circumstances.

Question 4

The first example of systematic risk that generally comes to mind is _______ risk. When the market tanks, virtually all securities lose value. This is a classic example of a nondiversifiable risk because, regardless of the number of different stocks in your portfolio, chances are most of those assets will have declined in price.

Answer 4

Market Risk

Question 5

Market Risk:
One way to protect against market risk is to have some _______ correlated securities in your portfolio like the VIX Index. Remember, they go up when the others go down. Options can also be used to hedge against market risk.

Answer 5

negatively

Question 6

Market Risk:
Market risk is measured by a security’s ________.

Answer 6

beta

Question 7

_______ Risk:
Example:
Should a war break out between two major oil-producing countries, the stock market could decline dramatically. The stocks of individual companies would likely decline as well, regardless of whether the war directly affected their businesses.

Answer 7

Market Risk

Question 8

_________ Risk:
Interest rates fluctuate in the market all the time. If market conditions or the Federal Reserve push interest rates higher, the market price of all bonds will be affected. When interest rates rise, the market price of bonds falls and that is why this is a systematic risk.

Answer 8

Interest Rate Risk

Question 9

Interest Rate Risk:
This risk is sometimes referred to as the most common risk for bonds. Rising interest rates can be _______ for some common stock prices as well, particularly those of ________ companies such as public utilities. Having a diversified portfolio of bonds won’t help because an increase in interest rates will cause all bonds to decline in price.

Answer 9

bearish
highly leveraged

Question 10

Interest Rate Risk:
Interest rate risk is intrinsic to all types of fixed-income investments, such as debt securities and ____ stock, whether from an ________ market issuer or a triple-A issuer. It is the risk that a security’s value will decline because of an increase in market interest rates.

Answer 10

preferred stock

emerging market issuer

Question 11

Interest Rate Risk:
Example:
If the Federal Reserve increases interest rates dramatically, the market price of all bonds, regardless of ______, will decline.

Answer 11

credit quality

Question 12

Interest Rate Risk:
Even some common stock investments have interest rate risk. These are common shares of public utility companies.

There are two reasons for public utility stocks being interest rate sensitive:
1. Public utility stocks are known for their ______ policies. When a stock’s price is largely determined by its dividend yield (the case with most utilities), as interest rates go up, their stock prices go down. This is true of public utility stocks more than any other common stock.

2. Public utility companies are highly leveraged. That is, they are ______ money. As interest rates go up, so does the utility’s borrowing cost. That will have the effect of lowering the income and possibly reducing the dividend.

Answer 12

liberal dividend

regularly borrowing

Question 13

Interest Rate Risk:
Bond Ladder / CD Ladder:
A popular way of reducing interest rate risk is by laddering a bond or CD portfolio. Picture a ladder. You see rungs at set intervals going from bottom to top. That is the concept behind a laddered portfolio. In a laddered strategy, the bonds are all ________ at the same time but _______ at different times (like the steps on the ladder). As the shorter maturities come due, they are reinvested and now become the long-term ones. This has also been a very common strategy with those purchasing CDs at their local bank.

Answer 13

purchased
mature

Question 14

Reinvestment Risk:
A close cousin of interest rate risk is reinvestment risk. There is reinvestment risk of BOTH _____ and ______.

Answer 14

interest

principal

Question 15

_________ Risk:
An investor receiving a periodic cash flow from an investment, such as interest on a debt security, may be unable to reinvest the income at the same rate as the security itself is paying.

Answer 15

Reinvestment Risk

Question 16

Reinvestment Risk:
Example:
If an investor purchased a bond with a 10% coupon and several years later comparable securities were paying only _____%, the investor would not be able to reallocate the investment at the original rate. _______ bonds avoid this risk because there is nothing to reinvest.

Answer 16

7%

Zero-coupon

Question 17

Reinvestment Risk:
This risk occurs at ________. If the fixed-income investor was enjoying a 10% return on the earlier bond, when it matured, the investor was able to reinvest the principal only in a 7% security. That is one of the advantages of purchasing bonds with a _______ time until maturity, you’re assured the fixed return for that length.

Answer 17

maturity
longer

Question 18

Inflation Risk (Purchasing Power Risk):
Inflation risk is another systematic risk. Inflation reduces the _______ of a currency.

Answer 18

buying power

Question 19

Inflation Risk (Purchasing Power Risk): __________ inflation points to a healthy, growing economy. _______ inflation causes uncertainty among individual investors as well as corporate managers attempting to evaluate potential returns from projects.

Answer 19

modest
Uncontrolled

Question 20

Inflation Risk (Purchasing Power Risk):
_________ securities are purchased to provide some protection against inflation risk.

Answer 20

Treasury Inflation-Protected Securities (TIPS)

Question 21

Inflation Risk (Purchasing Power Risk): _________ securities are the most vulnerable to this risk; ________ securities are historically the least susceptible.

Answer 21

Fixed-income

equity (stock)

Question 22

Inflation Risk (Purchasing Power Risk): Tangible assets such as ______and precious metals like _______ are also good inflation hedges.

Answer 22

real estate

gold

Question 23

Inflation Risk (Purchasing Power Risk): Example:
Let’s assume that an individual nearing retirement took $1 million and, seeking income with safety, invested $100,000 into each of 10 different corporate bonds, all maturing in 20 years. For sure, this diversification does give protection against financial risk. (If one of the bonds defaults because of bankruptcy of the issuer, the other nine should still pay off.) However, if the cost of living rises, 20 years from now—when each of those bonds pays back the $100,000 principal—the investor will have $1 million. How much do you think that $1 million of buying power would purchase compared with what it would have purchased 20 years earlier?

Answer 23

Less Buying Power

Purchasing power risk is a systematic risk, meaning that diversifying a portfolio is of little or no help.

Question 24

Nonsystematic (Unsystematic) Risk: Nonsystematic risks are unique to the specific ______ or _______ enterprise and include things such as labor union strikes, lawsuits, and product failure. Nonsystematic risks can be reduced through _______. This risk is higher for investors whose portfolios contain stock in only one issuer or in lower-rated bonds.

Answer 24

industry

business

diversification

Question 25

Business Risk: Business risk is an ______ risk, generally caused by poor management decisions (e.g., Edsel, New Coke, or more recently, Blackberry's former developers failing to pay attention to the success of the iPhone).

Answer 25

operating risk

Question 26

Business Risk: At best a corporation’s, earnings are ______; at worst, the company goes ______ and common stockholders probably lose their entire investment.

Answer 26

lowered out of business

Question 27

Credit / Default / Financial Risk: Often confused with business risk (it is similar), financial risk relates primarily to those companies that use _________. An inability to meet those _______ could lead to bankruptcy and, once again, total loss for the stockholders.

Answer 27

debt financing (leverage) debt obligations

Question 28

Nonsystematic (Unsystematic) Risk: Example: A client long 1,000 shares of MNO who sells those shares and invests the proceeds into an S&P index fund eliminates (or greatly reduces ________ but not ________. In similar fashion, owning a diversified portfolio of bonds, such as is offered in a bond fund, offers protection against _______ risk.

Answer 28

business risk (but not market risk) financial, credit, default risk

Question 29

Regulatory Risk: Regulatory risk comes from a change to regulations. A sudden change in the regulatory climate can have a dramatic effect on the performance or risk of a business and entire business _______.

Answer 29

sectors

Question 30

Regulatory Risk: Overreaching bureaucrats and ______ that change the rules a business must comply with can devastate individual companies and industries almost overnight.

Answer 30

court judgments

Question 31

Regulatory Risk: Example: A onerous rulings by the Environmental Protection Agency, which have at times disrupted the oil and gas industry. Investments that could be affected by regulatory changes include _______ industries,

Answer 31

Green Industries and those that tend to pollute like; oil and gas exploration, airlines, and pharmaceutical manufacturers.

Question 32

Legislative Risk: Legislative risk results from a change in the law. A governmental, state, or federal agency may pass certain regulations, but only a ______ can pass a law. Changes to the ______ are the most obvious legislative risks.

Answer 32

Congress & the Legislature tax code

Question 33

Political Risk: Political risk is mostly attributed to potential instability in the political underpinnings of a third world country outside of the U.S. (think of a coup). This is most common in______ economies, but as history has shown, political insurrection may occur even in _______ countries. (Brexit)

Answer 33

emerging developed

Question 34

Sovereign Risk: Sovereign risk ratings capture the risk of a _______ defaulting on its commercial debt obligations.

Answer 34

country

Question 35

Sovereign Risk: Example: Headlines were made several years ago when the credit rating of the United States was reduced from ____. That is an example of the perceived increased sovereign risk that existed at the time.

Answer 35

AAA

Question 36

Regulatory Risk: Example: The most common regulatory risk comes from governmental agency attempts to control or influence product _____ or the competitive _____ of a particular industry through the passage and enforcement of regulations (ex. Gas and oil).

Answer 36

prices structure

Question 37

Legislative Risk: Example: An example of legislative risk is how the domestic executive jet and boat-building business in the United States was devastated in 1990 after the federal government imposed a _____ on those items. The was repealed three years later when it became clear that the unintended consequence was the near bankruptcy of two sizable financial industry sectors.

Answer 37

luxury tax

Question 38

Political Risk: Example: A recent example of political risk was the actions of the Chavez government in Venezuela several years ago, where ______ took place in many industries, ranging from cement to supermarkets. Those investors, in what were ______ businesses lost most, if not all, of their investment.

Answer 38

nationalization previously privately owned (not government-owned)

Question 39

Liquidity Risk: Liquidity measures the _____ or ____ of converting an investment into cash without causing a price _______.

Answer 39

speed or ease disruption

Question 40

Liquidity Risk: This is the risk that when an investor wishes to dispose of an investment, _____ will be willing to buy it or that a very large purchase or sale would not be possible at the current price

Answer 40

no one Although there is technically a difference, for exam purposes, you may also refer to this as marketability risk.

Question 41

Liquidity Risk: Example: The Treasury bill market is a highly liquid market because investors can sell a Treasury bill within ______ at the quoted prices. Real estate investments, however, can take ______ to sell if you want to get close to your asking price. The longer it takes to convert an investment into cash without having a discounted fire sale, the greater the liquidity risk.

Answer 41

seconds months or years

Question 42

Liquidity Risk: Listed stocks and mutual funds have virtually _____ liquidity risk. Thinly traded stocks, many municipal bonds, and most tangible assets have a _____ liquidity risk.

Answer 42

no High

Question 43

Currency or Exchange Rate Risk: Purchasers of foreign securities, whether through ______ or ________, face the uncertainty that the value of either the foreign currency or the domestic currency will fluctuate. As a result, someone who invested one year ago in the stock of a company domiciled in the eurozone will find that, even if the stock has remained level or slightly lower on its local market, in terms of dollars the value has increased. On the other hand, if your funds are in _______, you have little if any exposure to currency or exchange rate risk.

Answer 43

direct ownership or American depositary receipts (ADRs) domestic cash or cash equivalents

Question 44

Currency or Exchange Rate Risk: Example: You take a trip to Country A and purchase a dinner on your credit card for 200 units of the local currency. On the final night of your stay, you go to the same restaurant, order the same meal, and once again, the bill is for 200 units. When you get home, you check your credit card statement and see that you were billed $100 for the first meal and $110 for the second. What happened? And how was the bill adjustment calculated ?

Answer 44

The value of the foreign currency rose against the U.S. dollar from $0.50 ($100 ÷ 200) to $0.55 ($110 ÷ 200). Even though no prices changed in the foreign country, you encountered currency risk. On an individual level, the exam may ask you about exchange rates and vacationers.

Question 45

You may need to know that the three primary SYSTEMATIC (NON-SPECIFIC) risks are 1. 2. 3.

Answer 45

1. Market 2. Interest Rate 3. Purchasing Power or Inflation (Money In Purse)

Question 46

You should also know the five primary NON-SYSTEMATIC (SPECIFIC) risks: 1. 2. 3. 4. 5.

Answer 46

1. Business 2. Financial/Credit/Default 3. Liquidity/Marketabiliyy 4. Political 5. Regulatory (Bishes Freaking Lie to the Police Regarding )

Question 47

Risk Disclosures: Control Relationships: A control relationship exists when a broker-dealer is owned by, is under common ownership with, or owns an entity that issues securities. It could be thought of as being part of the same family. When it comes to a recommendation, one would have a natural bias toward that entity. There are no problems with this relationship as long as it is _____. Control relationships can lead to significant ________.

Answer 47

disclosed conflicts of interest

Question 48

Risk Disclosures: Control Relationships: There are similar types of relationships where a conflict of interest could exist and that could affect the ability of the member or its representatives to give totally unbiased information. The best way to avoid these conflicts of interest is to disclose them so that the ______ can decide what to do.

Answer 48

customer

Question 49

Risk Disclosures: Control Relationships: Some examples of potential conflicts of interest are - offering a proprietary product, such as a ______ fund (a mutual fund where the underwriter or adviser is affiliated with the broker-dealer). - offering a limited partnership offering (direct participation program or DPP) where the sponsor is an _____ of the broker-dealer, program sponsors, such as investment companies or insurance companies, providing incentives or rewards to agents for selling the sponsors' products. - a securities professional having a _______ in any security being recommended. - a broker-dealer going public and placing shares of its _____ stock into discretionary accounts. - a broker-dealer publishing a favorable research report after ______ the issuer's stock offering. This is just a sample. The key point is if there is any doubt about the transparency of the recommendation or transaction, be sure to make fair disclosure.

Answer 49

House Affiliate Financial Interest Own underwriting

Question 50

Regulation Fair Disclosure (FD): Regulation Fair Disclosure (FD) is an SEC rule dealing with issuers disclosing information that can affect the price of the stock. Before passage of this rule, there was always a risk to the individual investor that an issuer might disclose ________ to certain institutional investors or analysts at a broker-dealer that was a market maker in the company's stock. This puts the ____ investor at a distinct uninformed disadvantage.

Answer 50

material nonpublic information (MNPI) retail

Question 51

Risk Disclosures: Control Relationships: Example: Suppose you were selling shares of a company where your sister was the CEO. Do you think you'd have to disclose that potential conflict to your clients?

Answer 51

Yes

Question 52

Regulation Fair Disclosure (FD): Before passage of this rule, there was always a risk to the individual investor that an issuer might disclose material nonpublic information (MNPI) to certain institutional investors. When these disclosures are made intentionally that would require an _________ public disclosure of the information. Almost all Regulation FD disclosures are for unintentional leaks. When that happens, the issuer must make _______ public disclosure. The SEC has agreed that public conference calls, press releases or press conferences, and webcasts are _______ compliant methods of public disclosure.

Answer 52

immediate prompt disclosure (defined as before the next trading day) FD-compliant

Question 53

Tender Offers: It is not uncommon for one company to attempt to take over another by acquiring a large percentage of its _____ shares. This is called a tender offer.

Answer 53

voting

Question 54

Tender Offers: A tender offer may also be made by an _______ of noncallable bonds when interest rates have fallen. Without the call feature, this would be the best way to _______ the old high-interest rate bonds.

Answer 54

issuer retire

Question 55

Tender Offers: The SEC defines tender offer as "an active and widespread solicitation by a company or third party (often called the _____ or ______) to purchase a substantial percentage of the company's securities. These types of investors may conduct tender offers to acquire equity (common stock) in a particular company or debt issued by the company."

Answer 55

bidder or offeror

Question 56

Tender Offers: In general, tender offers for equity securities need ______ approval. The nature of these offers requires adequate disclosures to clients. Usually, the tender offer is at a premium to the most recent trade, so it can be a good deal for the client. There is a _____ limit. If the client is not aware of that and misses it, not only will the client be unhappy but it could lead to an ______ case against the firm and/or the registered representative.

Answer 56

shareholder Time limit arbitration

Question 57

Tender Offers: Here are some testable dates: • The tender offer, unless withdrawn, under Regulation 14E, must remain open for at least _____ business days from the date the offer is first announced. • If the terms of the offer are changed, the revised offer must remain open for at least _____ business days from the commencement or _____ business days from the date the terms are changed. • The target company, within _____ business days of the announcement, must provide its shareholders with a statement: - accepting or rejecting the offer - expressing _____ on the offer - ______ to take a position on the offer.

Answer 57

20 business days 20 business days 10 business days 10 business days no opinion unable

Question 58

Tender Offers: Shareholders of the target company are permitted to tender shares only to the extent of their ______ position. That means shareholders cannot ______ shares back to the company that they do NOT own. There is one important prohibited action which is called _______.

Answer 58

net long sell short tendering

Question 59

Tender Offers: Example: A customer is long 400 shares of ABCD in a cash account and short 100 shares of the stock in a margin account. If ABCD becomes the target of a tender offer, the customer would be permitted to tender 300 shares, which is the net long position. If the customer were permitted to tender the 400 shares in the cash account and the tender offer was successful in acquiring all the outstanding shares, the customer would be short ____ shares with no way to cover because they own all available shares. A company is considered long a stock if the customer owns • the ______ • a convertible security and has issued _______ instructions • a call option and has issued _______ instructions.

Answer 59

100 stock conversion exercise

Question 60

Tender Offers: There is a special rule for a partial tender. If a tender offer is for less than 100% of the outstanding shares or is contingent on a minimum number of shares being tendered, holders of convertible securities can _______ without converting first. That way they will only be required to convert if their tender offer is ______.

Answer 60

tender accepted

Question 61

Tender Offers: Practice Question: An investor is long 300 shares of ABCD in a cash account and short 300 shares of ABCD in a margin account. A tender offer for ABCD is announced. How many shares may be tendered by the investor? A. 0 B. 300 C. 600 D. 900

Answer 61

Answer: A 0 Only the investor's net long position may be tendered. The investor's long position of 300 shares is fully offset by the short position of 300 shares. No shares can be tendered in this situation.

Question 62

SEC Rule 10b-18: This rule deals with an issuer buying back its own stock in the open market. If an issuer wants to buy back its own securities in the open market, SEC Rule 10b-18 applies. Transactions cannot affect the opening or closing price of the security. To be safe, the issuer can't be involved in the first trade at the opening or do any purchasing in the final 30 minutes of the trading day. Transactions can be executed at prices not higher than the highest independent _____ or the last reported _____ price, whichever is higher.

Answer 62

30 minutes (3:30–4:00 pm ET) Bid Sale

Question 63

When a client opens a margin account, the _____ must be furnished.

Answer 63

Margin Risk Disclosure Document

Question 64

Specified Adult Exploitation: Member firms and their associated persons must pay close attention to the accounts of specified adults, such as those age _____ and over. They are frequently easy targets for scam artists. Amazingly, a very high percentage of the financial abuse is committed by their own family members.

Answer 64

65

Question 65

Specified Adult Exploitation: What exactly does FINRA consider financial exploitation? Financial exploitation is considered the _______ or _______ taking, withholding, appropriation, or use of a specified adult's funds or securities, or any act or omission taken by a person, including through the use of a power of attorney, guardianship, or any other authority, regarding a specified adult to obtain control through deception, intimidation, or undue influence over the specified adult's money, assets, or property, or convert the specified adult's money, assets, or property.

Answer 65

wrongful or unauthorized

Question 66

Specified Adult Exploitation: Prevention: Here are some suggested steps that member firms might want to take to prevent exploitation of their senior clients: • There should be clear, written procedures specifically addressing the needs of these clients. • Personnel should be given a plan showing what to do when exploitation is suspected. That would include how to escalate the concern. • Keep up with the regulations including the federal _______. • Training and more training.

Answer 66

Senior Safe Act

Question 67

Specified Adult Exploitation: • Rule 2165 provides for a _____but only when the member firm can document proper training of personnel. The training should point out the red flags to look for, such as cognitive decline and unusual activity in the account.

Answer 67

safe harbor

Question 68

Specified Adult Exploitation: Take preemptive action. When a registered representative notices changes, reach out to the ______ before anything happens as long it’s not the suspected abuser.

Answer 68

trusted contact person

Question 69

Specified Adult Exploitation: Safe harbor in reporting senior exploitation is only available if the report is made to an _____, the purpose of which includes protection of seniors. If the report is made to some other random person, known as a _____, there is no protection from liability.

Answer 69

appropriate government agency third party

Question 70

Tender Offer: In a tender offer, the ______ is offering to buy back all or a portion of the issue at a stated price from existing investors. The price of the tender is set by the issuer although the issuer may engage an _____ to help it set the price. This could happen when interest rates have gone up, causing the price of the outstanding bonds to fall. From a practical standpoint, this would mean the corporation paying off their bond debt at a price ____ face value.

Answer 70

issuer underwriter below

Question 71

Liquidity Risk: Institutional managers are moving to increase their cash position. This action would be viewed as a _______ technical indicator. When investment managers liquidate securities to increase their cash positions, stock prices are likely to fall.

Answer 71

Bearish

Question 72

In FINRA's eyes, this is all about making sure that associated persons of the firm are adequately (and frequently) trained. Although customer and firm assets must be segregated, that is not part of the senior exploitation rule. The rule permits, but does not _____, that these holds be placed on disbursements from the affected accounts−it is _____. Detailed reports must be made and retained, containing the relevant information leading to the decision to enforce the hold.

Answer 72

require voluntary

Question 73

Tender Offers: If a tender offer is ______, it must remain in effect until the original offer expires or until ______ business days after the revision takes effect, whichever comes later.

Answer 73

revised 10 business days

Question 74

Volatility: The more a stock's beta increases above 1.0, the greater the ______ of the returns when compared to those of the overall market. A beta below 1.0 indicates less when compared to those of the overall market.

Answer 74

variability

Question 75

Interest Rate Risk: One of the features of a unit investment trust is that it has a defined end date. The bonds held in the UIT in our question all mature in five years. Regardless of how high _____ rise, bonds pay off at face value when they mature.

Answer 75

current market interest rates

Question 76

• A money management strategy that switches among asset classes based upon anticipated market moves is ________. • _________ is a passive strategy that makes no attempt to anticipate market moves. An index strategy reflects an underlying index, with the adviser keeping securities in the portfolio in proportion to their weight in the underlying index. • _______ investing seeks to actively invest in securities that are selling at a discount to their book value and out of favor with the market. • _______ is a method of acquiring shares at a lower average cost over time and is not an investment style.

Answer 76

asset allocation Indexing Value Investing Dollar cost averaging

Question 77

Market Risk: Because the client has reallocated the portfolio into highly conservative assets, cash and cash equivalents , one would think the manager is expecting a _____ market. This new allocation is an attempt to protect against incurring losses from the anticipated market decline.

Answer 77

Bearish

Question 78

Tender Offers: Investors can tender only shares they are long. The tender price is $16 per share above the current market price, and the customer wants to take advantage of the offer. The customer's account is long 300 shares of the stock. The customer also owns 10 of the issuer's convertible debentures, each with a conversion price of $25 per share. At your suggestion a month ago, the customer purchased three protective puts on the stock. Assuming all requirements were met, the maximum number of shares this customer could tender is?

Answer 78

700 Shares In addition, as long as the debentures are converted before the tender deadline, the customer is long 400 more shares ($1,000 debenture ÷ $25 conversion price = 40 shares per debenture; 10 debentures = 400 shares). That makes the customer long 700 shares. The puts cannot create a long position in the stock; they only give the customer an opportunity to sell the stock at the exercise price. If they were calls and were exercised before the deadline, they would be an additional 300 long shares.