Module 1: Economic Factors and Business Information

• Topic 01

  Basic Economic Concepts

  158 questions
• Topic 02

  Financial Reporting

  159 questions
• Topic 03

  Analytical Methods

  240 questions
• Topic 04

  Types of Risk

  190 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. Stock A has expected return 10% and SD 20%. Stock B has expected return 10% and SD 20%. If the correlation between A and B is −0.5 and they are equally weighted, the portfolio SD will be approximately 14.1%. If correlation were +1.0, the portfolio SD would equal 20%. What does this comparison illustrate?

   • A
     The diversification benefit of negative correlation — combining negatively correlated assets reduces portfolio SD below either individual asset's SD, while perfect positive correlation provides zero diversification benefit
     Correct answer
   • B
     Negative correlation increases expected return above either individual asset's expected return
   • C
     Perfect positive correlation doubles portfolio risk by creating compounding volatility effects
   • D
     A portfolio SD of 14.1% means the portfolio has eliminated all systematic risk
   Explanation

   This comparison directly illustrates the core principle of diversification. At correlation +1.0: portfolio SD = 20% (no benefit — assets move perfectly together). At correlation −0.5: portfolio SD ≈ 14.1% (meaningful reduction below either asset's 20% SD). The diversification benefit here is 20% − 14.1% = 5.9 percentage points of SD reduction, achieved with no sacrifice in expected return (both assets have 10% expected return). This illustrates that diversification is essentially a free lunch — reducing risk without reducing expected return by selecting assets with lower pairwise correlations. Negative correlation provides the greatest benefit; zero correlation provides moderate benefit; positive correlation provides diminishing benefit.

2. How does a company's leverage ratio affect its financial risk?

   • A
     Higher leverage means the company has more fixed debt obligations; if earnings decline, the company may struggle to service its debt, increasing the risk of financial distress or default
     Correct answer
   • B
     A higher leverage ratio generally indicates the company has a higher credit rating
   • C
     Leverage reduces financial risk by diversifying the company's funding sources across debt and equity
   • D
     Leverage only affects financial risk when the company has a payout ratio above 50%
   Explanation

   Financial leverage amplifies both gains and losses. When a company borrows to fund operations, it takes on fixed interest obligations. In bad times, if operating cash flow declines, the company still must service its debt—increasing the risk of covenant violations, credit rating downgrades, or default. Debt-to-equity and interest coverage ratios are the primary tools analysts use to assess leverage and financial risk.

3. An investment adviser recommends a 100% equity portfolio to a 72-year-old retired client citing 'long-term superior performance.' The client suffers a 40% loss in a market downturn and must sell holdings to fund living expenses. What fiduciary principle has been violated?

   • A
     No fiduciary principle was violated; equities generally outperform in the long run.
   • B
     The adviser violated the fiduciary duty of suitability — the recommendation failed to match the client's actual risk capacity (needing income and capital preservation) despite the theoretical long-term performance advantage of equities.
     Correct answer
   • C
     The adviser was correct; a 72-year-old should hold equities for inflation protection.
   • D
     The adviser violated only the disclosure principle by not providing performance data.
   Explanation

   Suitability under the fiduciary standard requires that risk-taking matches the client's actual capacity to absorb losses, not just theoretical long-run returns. A 72-year-old retiree drawing on assets for income cannot withstand a 40% drawdown without being forced to sell at depressed prices, locking in losses. Risk capacity is as important as risk tolerance.