LOMA 357

Chapter 4
Reference: c. 4, pp. 2-3
Types of investment income include interest income, dividend income, and rental
income. One type of investment that produces dividend income, but no interest
income or rental income, is

A. commodities
B. common stocks
C. bonds
D. mortgages
Reference: c. 4, pp. 2-3
Sources of income differ by investment type. With respect to various investment
types and the sources of income associated with them, it is correct to say that

A. common stocks provide dividends, but no interest payments or rent

B. bonds provide dividends and interest payments, but no rent
C. mortgages provide interest payments and rent, but no dividends
D. real estate provides dividends and rent, but no interest payments
Reference: c. 4, p. 3
Wanda Avren had invested a principal amount of $20,000. At the end of one year,
her investment earned a return of $800. Ms. Avren's rate of return on her
investment is

A. 1.5%
B. 2.0%
C. 4.0%
D. 8.0%
Reference: c. 4, p. 6
The required return for an investment is correctly defined as the

A. rate of return on an investment after adjustment for inflation and potentially

some other systemic effects
B. annual rate of investment return an investor requires as reasonable
compensation for a given level of risk and to satisfy the investor's objectives
C. total amount or annual rate of return an investor expects an investment to
earn, given market forces affecting the investment
D. rate of return on a risk-free investment
Reference: c. 4, p. 7
The paragraph below contains an incomplete statement. Select the answer choice
containing the term that correctly completes the statement.

To calculate the real rate of return on an investment, an investor subtracts the

__________ from the investment's nominal return.

A. hurdle rate
B. historical return
C. riskless rate
D. inflation rate
Reference: c. 4, pp. 6-7
An investor is using the following information to evaluate an investment:

● The interest rate on a three-month U.S. Treasury bill is 2%

● The inflation rate is 3%
● The risk premium for this investment is 5%
● The nominal return on this investment is 6%

From the answer choices below, select the response that correctly indicates this investment’s required return and its real
rate of return.

Required return Real rate of return

A. 7% 4%
B. 8% 5%
C. 10% 3%
D. 10% 11%
Reference: c. 4, p. 8
One measure of return is the rate of return on an investment over the entire period
of owning the investment. This measure of return, which is relevant primarily for
investments that are held for less than a full year, is known, by definition, as the

A. hurdle rate
B. holding period return (HPR)
C. total return
D. annualized rate of return
Reference: c. 4, pp. 8-9
An investment has the following annual rates of return over a holding period of
three years:
Year 1 Year 2 Year 3

Yearly Return 4% 5% 6%
This information indicates that, over three years, the arithmetic mean annual
return of this investment is

A. 2.0%
B. 4.0%
C. 5.0%
D. 9.0%
Reference: c. 4, p. 10
To measure investment volatility, investment professionals refer to the standard
deviation of asset prices over time. The higher the standard deviation of the
historical returns on an investment, the (less / more) an actual return can be
expected to vary from the expected historical return, and, therefore, the (less /
greater) the investment risk.

A. less / less
B. less / greater
C. more / less
D. more / greater
Reference: c. 4, p. 12
Tail risk is one risk concept in the normal curve for the historical returns of an
investment. The term tail risk generally signifies risks of

A. low-probability and low-impact occurrences

B. low-probability but high-impact occurrences
C. high-probability but low-impact occurrences
D. high-probability and high-impact occurrences
Reference: c. 4, p. 12
For this question, if answer choices (1) through (3) are all correct, select answer choice (4).
Otherwise, select the one correct answer choice.

The potential financial losses represented in the tails of statistical probability distribution curves
are collectively called tail risks. Correct statements about tails and tail risk include

I. that the term “tail risk” generally signifies risks of low probability but high impact occurrences
II. that the tails in a normal probability distribution curve represent about 5% of the area under
the curve
III. that, when the probability distribution curve represents investment returns, the values to the
left of the mean are the more desirable outcomes, whereas the values to the right of the
mean are unsatisfactory returns or even losses
IV. all of the above
Reference: c. 4, pp. 12-14
An investor is calculating the confidence interval of the expected return for U.S. large company
stocks at plus or minus one standard deviation from the mean. Over a 38-year period, these
stocks had a mean historical return of 6%, with one standard deviation of plus or minus 16%. In
addition, these stocks had an annual rate of return of 5% last year. Therefore, the investor
correctly calculated that a movement of plus or minus one standard deviation from the mean
would cause the expected return on these stocks to fall in a range from a loss of

A. –10 and a gain of 22, and the confidence level attached to these estimates is about 67%
B. –10 and a gain of 22, and the confidence level attached to these estimates is about 95%
C. –11 and a gain of 21, and the confidence level attached to these estimates is about 67%
D. –11 and a gain of 21, and the confidence level attached to these estimates is about 95%
Reference: c. 4, pp. 14-15
The interplay between risk and return in investing is known as the risk-return
trade-off. One example of an investment that typically results in lower levels of risk
and return-all other characteristics being equal-is

A. owning a loan that is unsecured by collateral rather than a loan that is

secured by collateral
B. owning an asset that is easy to sell at a fair value rather than an asset that is
difficult to sell at a fair value
C. owning a long-term bond rather than a short-term bond
D. lending to a borrower with a poor credit rating rather than lending to one with
a high credit rating
Reference: c. 4, pp. 14-15
The characteristics of a given investment transaction affect that investment’s expected risk and return.
The following statements are about the expected risks and returns for investments that differ only in one
specific risk characteristic. Select the answer choice containing the correct statement.

A. A long-term bond would typically have higher risk and a lower expected return than would an
otherwise identical short-term bond.
B. An investment that pays returns in the investor’s domestic currency would typically have lower risk
and a lower expected return than would an otherwise identical investment that pays returns in a
currency foreign to the investor.
C. A corporate bond rated “NAIC 1” would typically have higher risk and a higher expected return than
would an otherwise comparable corporate bond rated “NAIC 3.”
D. A loan to a borrower with a high credit rating would typically have lower risk and a higher expected
return than would an otherwise comparable loan to a borrower with a poor credit rating.
Reference: c. 4, p. 16
For operational guidance, the risk tolerance and risk appetite specified for the
investment function are often translated into quantifiable key risk indicators and
key performance indicators. A (key risk indicator / key performance indicator) is a
quantitative measure that indicates the level of potential adverse impact in a given
activity. A (key risk indicator / key performance indicator) directly addresses risk
tolerances.

A. key risk indicator / key risk indicator

B. key risk indicator / key performance indicator
C. key performance indicator / key risk indicator
D. key performance indicator / key performance indicator
Reference: c. 4, p. 17
For purposes of portfolio management, investment risks may be assigned to one
of two general categories: specific risks or systemic risks. From the answer
choices below, select the response that correctly identifies an example of specific
risk and an example of systemic risk.

Specific risk Systemic risk

A. credit risk liquidity risk

B. credit risk liquidity risk
C. Inflation credit risk
D. liquidity risk currency risk
Reference: c. 4, p. 17
The paragraph below contains two pairs of terms enclosed in parentheses. Determine which
term in each pair correctly completes the paragraph. Then select the answer choice
containing the two terms that you have chosen.

Two broad categories of risk are systemic risk and specific risk. Only risks that can be
modeled and managed in a portfolio qualify as (systemic / specific) risks. In addition, as
more assets are included in a portfolio, the impact of (systemic / specific) risk on returns
diminishes.

A. systemic / systemic
B. systemic / specific
C. specific / systemic
D. specific / specific
Reference: c. 4, p. 18
One correct statement about systemic risks and specific risks is that

A. systemic risks always have catastrophic impact

B. systemic risks have broad, similar effects on all elements in an economic
system
C. systemic risk can be substantially reduced by diversification
D. estimates of expected returns usually incorporate a risk premium for specific
risks
Reference: c. 4, p. 20
Interest rate risk is the risk that the market value of an investment will change due
to a change in the absolute level of market interest rates. For example, as market
interest rates increase, the market value of an existing bond generally
(decreases / increases), and the market value of an existing mortgage generally
(decreases / increases).

A. decreases / decreases
B. decreases / increases
C. increases / decreases
D. increases / increases
Reference: c. 4, p. 21
Duration is a statistic that measures the interest-rate sensitivity of an interest-
bearing security. The following statements are about duration. Select the answer
choice containing the correct statement.

A. Duration can be used with bond interest payments, but not with mortgage
amortization payments.
B. Insurance companies use uniform duration statistics.
C. Insurance companies are prohibited from using modified duration.
D. As the value of duration increases, risk increases.
Reference: c. 4, p. 21
If a security's duration is six years, then for a change of 1 percent in interest rates,
the market value of the security will change by

A. 1 percent in the same direction

B. 1 percent in the opposite direction
C. 6 percent in the same direction
D. 6 percent in the opposite direction
Reference: c. 4, p. 21
A portfolio of bonds with a market value of $500,000 has a duration of 7 years. If
interest rates decrease by 1%, then the market value of this bond portfolio will

A. decrease by $5,000
B. increase by $5,000
C. decrease by $35,000
D. increase by $35,000
Reference: c. 4, p. 22
Yield curves generally take on one of several shapes. When yields on long-term
securities are higher than yields on short-term securities, the yield curve takes on
the shape of

A. an inverted yield curve

B. a downward-slope curve
C. a normal yield curve
D. a flat yield curve
Reference: c. 4, p. 22
Yield curves generally take one of three shapes: normal, inverted, or flat. A normal
yield curve has

A. an upward slope from left to right and indicates that yields on long-term
securities are higher than yields on short-term securities
B. an upward slope from left to right and indicates that yields on short-term
securities are higher than yields on long-term securities
C. a downward slope from left to right and indicates that yields on long-term
securities are higher than yields on short-term securities
D. a downward slope from left to right and indicates that yields on short-term
securities are higher than yields on long-term securities
Reference: c. 4, p. 24
One type of risk that insurance companies face with their investments is credit
risk. Credit risk can correctly be defined as the risk that

A. market conditions will be unfavorable when an investor needs to invest the

proceeds from a prior investment
B. an asset might not be readily sold for its true value
C. a borrower may default by failing to make payments of principal or interest on
time
D. arises from changes in currency exchange rates
Reference: c. 4, p. 24
Credit risk is the risk that a borrower may default by failing to make payments of
principal or interest on time. The following statements are about credit risk. Three of
the statements are true, and one of the statements is false. Select the answer choice
containing the FALSE statement.

A. If a corporation does not repay a loan as promised, creditors have claims against
the corporation and its assets.
B. In many jurisdictions, creditors have certain legal rights against municipal
governments in the event of default.
C. Corporate credit risk includes components of event risk and financial risk.
D. Typically, sovereign debt is the most risky investment to be made in any given
economy.
Reference: c. 4, p. 27
Transaction risk is risk resulting from changes in the (interest rate / currency
exchange rate) between the time of entering into an agreement and the effective
time of a transaction. The greater the time between entering into the agreement
and settling the agreement, the (less / greater) the transaction risk.

A. interest rate / less

B. interest rate / greater
C. currency exchange rate / less
D. currency exchange rate / greater
Reference: c. 4, p. 28
For this question, if answer choices (1) through (3) are all correct, select answer
choice (4). Otherwise, select the one correct answer choice.

Liquidity risk in investments is the risk that an asset might not be readily sold for its
true value. Examples of investments that are considered to have limited liquidity
include

A. a bond issue of more than $500 million

B. large capitalization stocks
C. private placement bonds
D. all of the above