Investment Risk and Portfolio Management

INVESTMENT RISK
Investment risk is the probability or likelihood of losses relative to the expected return on any particular
investment. It is a measure of uncertainty of achieving the returns as per the investor's expectations.

3 Types of Risks
There are different types of risks that a firm might face and needs to overcome.
1. Business Risk
Business enterprises themselves take these types of risks to maximize shareholder value and
profits. For example, Companies undertake high-cost risks in marketing to launch a new product
to gain higher sales.

2. Non-Business Risk
These types of risks are not under the control of firms. Risks that arise out of political and
economic imbalances can be termed as non-business risks.

3. Financial Risk
Financial Risk, as the term suggests, is the risk that involves financial loss to firms. Financial risk
generally arises due to instability and losses in the financial market caused by movements in
stock prices, currencies, interest rates, and more.

a. Market risk
This type of risk arises due to the movement in the prices of financial instruments.
Market risk can be classified as Directional Risk and Non-Directional Risk. Directional
risk is caused due to movement in stock price, interest rates, and more. Non-Directional
risk, on the other hand, can be volatility risks.

b. Credit risk
This type of risk arises when one fails to fulfill their obligations towards their
counterparties. Credit risk can be classified into Sovereign Risk and Settlement Risk.
Sovereign risk usually arises due to difficult foreign exchange policies. On the other
hand, settlement risk arises when one party makes the payment while the other party fails
to fulfill the obligations.

c. Liquidity risk
This type of risk arises out of an inability to execute transactions. Liquidity risk can be
classified into Asset Liquidity Risk and Funding Liquidity Risk. Asset Liquidity risk
arises either due to insufficient buyers or insufficient sellers against selling orders and
buys orders.

d. Operational risk
This type of risk arises out of operational failures such as mismanagement or technical
failures. Operational risk can be classified into Fraud Risk and Model Risk. Fraud risk
arises due to the lack of controls, and Model risk arises due to incorrect model
application.
 Investment Risk and Portfolio Management

e. Legal risk
This type of financial risk arises out of legal constraints such as lawsuits. Whenever a
company needs to face financial losses out of legal proceedings, it is a legal risk.

Business enterprises themselves take these types of risks to maximize shareholder value and profits.

5 Ways to Measure Investment Risk

1. Value at Risk
This is one of the more widely used yet misunderstood risk measurements. VaR can be calculated in
many different ways, but it intends to measure the likelihood that future portfolio losses will remain
within a certain range. For example, if a portfolio has a one-day 2% VaR of P10,000, there is a 2%
probability that the portfolio will decline by more than P10,000 in a given day. This means we should
expect to see a decline greater than P10,000 no more than once every 50 days. The main problem
with VaR is how it has been calculated and applied. VaR is based on a normal distribution of return.
Since stock prices often have fat-tails, this premise fails, and we often see extreme results more
frequently than the model predicts. More importantly, the model does not offer us a maximum loss
but only a range in which returns should fail. If I had a P100,000 portfolio and a perfect VaR model
that accurately predicted I would only lose P5,000 one day every year, I would believe my
risk allocation was perfect. However, if on that one day, I lost P30,000, my risk is much too high. By
failing to capture the maximum potential loss, VaR has major limitations.

2. Risk Identification for Large Exposures (RIFLE)

RIFLE is another statistical risk measurement that makes up for the shortfalls of VaR. RIFLE is
focused on the maximum potential loss that could occur because of the large positions we hold. Since
it does not account for small daily movements, RIFLE will not help with daily risk management.
However, the focus on maximum loss is effective in determining whether we could survive maximum
draw-downs. Given the unique focus of each tool, a combination of VaR and RIFLE would serve an
investor well by providing daily risk measurements in addition to alerting us to the worst-case
scenario.

3. Shortfall
When we invest, we have a set monetary goal in mind. Pensions need to pay monthly checks to their
beneficiaries, and families with college-aged children must pay the tuition when the bill comes due.
For this reason, investors at all levels must manage the risk of a shortfall. Instead of focusing on
financial markets to determine potential risk, we should know when and where the funds are needed.
By focusing on such a long-term horizon, we prevent random statistics from skewing our portfolio
style.

4. Volatility
This is the most traditional measure of risk. When markets move wildly, our emotions may take
control and force us into poor decisions at the worst possible time. By focusing on volatility as a
measure of risk, we can account for the likelihood that poor decisions will short-circuit our
investment strategy.
 Investment Risk and Portfolio Management

5. Comfort
This is the most common-sense and perhaps most effective way to manage risk. If you look at your
positions and the market each day and cannot handle the stress, you probably take on too much risk.
One approach is to keep selling stocks until you reach the point where you can sleep. We are in the
markets to improve our wealth, not destroy our health. Maintain positions with which you are
comfortable, and you are more likely to make good decisions in the future.

Only by understanding the level of risk with which we are comfortable can investors determine how
to invest. Through any investment cycle, we should be mindful of our risk tolerance and our
investment strategy. By maintaining a consistent view, we eliminate market noise and prevent our
emotions from dictating our decisions. Always remember, when emotions enter the equation, our
portfolios usually suffer.
 Investment Risk and Portfolio Management

PORTFOLIO MANAGEMENT
An investment portfolio is a set of financial assets owned by an investor that may include bonds. The
bond issuer borrows capital from the bondholder. It makes fixed payments to them at a fixed (or variable)
interest rate for a specified period., stocks, currencies, cash and cash equivalents, and commodities.
Further, it refers to a group of investments that an investor uses to earn a profit while ensuring that capital
or assets are preserved.

Components of a Portfolio

The assets that are included in a portfolio are called asset classes. The investor or financial advisor needs
to make sure that there is a good mix of assets to maintain balance, fostering capital growth with limited
or controlled risk. A portfolio may contain the following:

1. Stocks
Stocks are the most common component of an investment portfolio. They refer to a portion or share
of a company. It means that the owner of the stocks is a part-owner of the company. The size of the
ownership stake depends on the number of shares he owns.

Stocks are a source of income because as a company makes profits, it shares a portion of the profits
through dividends. Also, as shares are bought, they can be sold at a higher price, depending on their
performance.

2. Bonds
When an investor buys bonds, he is loaning money to the bond issuer, such as the government, a
company, or an agency. A bond comes with a maturity date, which means the date the principal
amount used to buy the bond is to be returned with interest. Compared to stocks, bonds don’t pose as
much risk but offer lower potential rewards.

3. Alternative investments
Alternative investments can also be included in an investment portfolio. They may be assets whose
value can grow and multiply, such as gold, oil, and real estate. Alternative investments are commonly
less widely traded than traditional investments such as stocks and bonds.

Types of Portfolios
Portfolios come in various types, according to their strategies for investment.

1. Growth portfolio
A growth portfolio aims to promote growth by taking greater risks, including investing in growing
industries. Portfolios focused on growth investments typically offer both higher potential rewards and
concurrent higher potential risk. Growth investing often involves investments in younger companies
with more potential for growth than larger, well-established firms.

2. Income portfolio
An income portfolio is more focused on securing regular income from investments than focusing on
potential capital gains. An example is buying stocks based on the stock’s dividends rather than on a
history of share price appreciation.
 Investment Risk and Portfolio Management

3. Value portfolio
An investor takes advantage of buying cheap assets by valuation. They are especially useful
during difficult economic times when many businesses and investments struggle to survive and stay
afloat. Investors, then, search for companies with profit potential but are currently priced below what
analysis deems their fair market value. In short, value investing focuses on finding bargains in the
market.

Capital Asset Pricing Model (CAPM)

The CAPM describes the relationship between systematic risk and expected return for assets, particularly
stocks. CAPM is widely used throughout finance for pricing risky securities and generating expected

Investors expect to be compensated for risk and the time value of money. The risk-free rate in the CAPM
formula accounts for the time value of money. The other components of the CAPM formula account for
the investor taking on additional risk.

The beta of a potential investment is a measure of how much risk the investment will add to a portfolio
that looks like the market. If a stock is riskier than the market, it will have a beta greater than one. If a
stock has a beta of less than one, the formula assumes it will reduce a portfolio's risk.

A stock’s beta is then multiplied by the market risk premium, which is the return expected from the
market above the risk-free rate. The risk-free rate is then added to the product of the stock’s beta and the
market risk premium. The result should give an investor the required return or discount rate to find the
asset's value.

The CAPM formula's goal is to evaluate whether a stock is fairly valued when its risk and the time value
of money are compared to its expected return.

For example, imagine an investor is contemplating a stock worth P100 per share today that pays a 3%
annual dividend. The stock has a beta compared to the market of 1.3, which means it is riskier than a
market portfolio. Also, assume that the risk-free rate is 3%, and this investor expects the market to rise in
value by 8% per year.

The expected return of the stock based on the CAPM formula is 9.5%:

The CAPM formula's expected return is used to discount the expected dividends and capital appreciation
of the stock over the expected holding period. If the discounted value of those future cash flows is equal
to P100, then the CAPM formula indicates the stock is fairly valued relative to risk.
 Investment Risk and Portfolio Management

TESTBANK
1. A feasible portfolio that offers the highest expected return for a given risk or the least risk for a given
expected return is a(n)
a. Efficient portfolio.
b. Effective portfolio.
c. Desirable portfolio
d. Optimal portfolio.
ANS: A
A feasible portfolio that offers the highest expected return for a given risk or the least risk for a given
expected return is called an efficient portfolio.

2. The systematic risk of an individual security is measured by the

a. The standard deviation of the security’s rate of return.
b. Security’s contribution to the portfolio risk.
c. Covariance between the security’s returns and the general market.
d. The standard deviation of the security’s returns and other similar securities.
ANS: C
The covariance is a measure of the mutual volatility of two securities. The covariance between the return
of single security and the return on the market as a whole is, therefore, the systematic (or market) risk of
the single security.

3. An optimal portfolio of investments is

a. Tangent to the investor’s highest indifference curve
b. Any portfolio is chosen from an efficient set of portfolios.
c. Efficient because it offers the highest expected return.
d. Any portfolio is chosen from the feasible set of portfolios.
ANS: A
An investor wants to maximize expected return and minimize risk when choosing a portfolio. A feasible
portfolio that offers the highest expected return for a given risk or the least risk for a given expected
return is efficient. A portfolio selected from the efficient set of portfolios because it is tangent to the
investor's highest indifference curve is optimal.

4. A company holds industrial development bonds issued by a county in another state. The county
commission has announced that its financial condition has changed drastically and that it is considering
defaulting on the next interest and principal payment on these bonds. This situation exposes the company
to all of the following types of risk except
a. Credit risk.
b. Interest rate risk.
c. Political risk.
d. Liquidity risk
ANS: B
 Investment Risk and Portfolio Management

Interest rate risk is the risk that investment security will fluctuate in value due to changes in interest rates.
The potential default is based on the issuer’s financial condition, not the market's movement of interest
rates.

5. Upon the death of an officer, Jung Co. received the proceeds of Jung's life insurance policy on the officer.
The proceeds were not taxable. The policy’s cash surrender value had been recorded on Jung’s books at
the time of payment. What amount of revenue should Jung report in its statements?
a. Proceeds received plus cash surrender value.
b. Proceeds received less cash surrender value.
c. Proceeds received.
d. None.
ANS: B
When a company insures employees' lives and names itself as the beneficiary, the policy's cash surrender
value (CSV) is considered an asset. Premiums paid are debited to CSV for the increase in CSV that year,
and insurance expense for the excess of cash paid over an increase in CSV. Upon the insured employee's
death, the company recognizes a gain for the excess of proceeds received over CSV.

6. The CFO of a publicly-traded company expects to pay a dividend next year of P1.25 and project that its
stock price will be P45 in 1 year. The CFO has determined that the required rate of return for Clean
Waterworks is 10%. Based on the data available, what is the value of one share of the company’s stock
today?
a. P42.05
b. P51.39
c. P46.25
d. P45
ANS: A
The value of one share of stock today is the stock price at the end of the year plus the dividend received,
discounted back one year by the required rate of return. Thus, the stock's value at the end of the year is
P46.25 (P45 plus the P1.25 dividend). This must be discounted back to today to equal P42.05 (P46.25 /
1.10).

7. One type of risk to which investment securities are subject can be offset through portfolio diversification.
This type of risk is referred to as
a. Company risk.
b. Market risk.
c. undiversifiable risk.
d. Liquidity risk.
ANS: A
Unsystematic risk, also called the company or diversifiable risk is the risk inherent in particular
investment security. Since individual securities are affected by the issuer's particular strengths and
weaknesses, this risk can be offset through portfolio diversification.
 Investment Risk and Portfolio Management

8. The returns on two stocks can be correlated in values except those that are
a. Skewed.
b. Neutral.
c. Positive.
d. Negative.
ANS: A
The correlation coefficient (r) measures the degree to which any two variables are related. It ranges from
+1.0 to 1.0. A perfect positive correlation (1.0) means that the two variables always move together. A
perfect negative correlation (+1.0) implies that the two variables always move inversely to one another. A
neutral correlation, or no correlation, is 0.0. Skewed is a nonsense concept in this context.

9. A market analyst has estimated the equity beta of Modern Homes, Inc. to be 1.4. This beta implies that
the company's
a. Systematic risk is lower than that of the market portfolio.
b. Total risk is higher than that of the market portfolio.
c. Systematic risk is higher than that of the market portfolio.
d. Unsystematic risk is higher than that of the market portfolio.
ANS: C
Systematic risk is also called market risk, and undiversifiable risk is the stock market's risk as a whole.
Some conditions in the national economy affect all businesses, so equity prices so often move together.
The effect of individual security on a portfolio's volatility is measured by its sensitivity to the overall
market's movements. This sensitivity is stated in terms of a stock beta coefficient. An average-risk stock
has a beta of 1.0 because its returns positively correlate with those on the market portfolio.

10. The risk to which all investment securities are subject is known as
a. Credit risk.
b. Systematic risk.
c. Unsystematic risk
d. Diversifiable risk.
ANS: B
Systematic risk, also called market risk, is the risk faced by all firms. Changes in the economy as a whole,
such as the business cycle, affect all players in the market. For this reason, systematic risk is sometimes
referred to as undiversifiable risk. Since all investment securities are concerned, this risk cannot be offset
through portfolio diversification.

11. An increase in the cash surrender value of a life insurance policy owned by a company would be recorded
by
a. Recording a memorandum entry only.
b. Increasing investment income.
c. Decreasing annual insurance expense.
d. Decreasing a deferred charge.
ANS: C
 Investment Risk and Portfolio Management

When a company insures employees' lives and names itself, the beneficiary, the policies' cash surrender
value is considered an asset. During the first few years of a policy, no cash surrender value may accrue. If
no increase in cash surrender value (CSV) occurs, the journal entry to record a premium paid would be
Insurance expense xxx Cash xxx. However, if cash surrender value increases, part of the cash paid is
recorded as an increase in the CSV. The entry is Insurance expense xx Cash surrender value xx Cash xxx.
Therefore, the rise in CSV decreases insurance expenses because the same amount of cash paid must be
allocated between the two accounts. The rise in CSV does not affect investment income or deferred
charges.

12. A company is considering expanding its international operations. Which one of the following conditions
should the Company's controller classify as a political risk?
a. Accelerating inflation of the host country.
b. Expropriation of the plant after construction.
c. Declining home-country currency values.
d. Different accounting methods between home and host countries.
ANS: B
Political risk is the probability of loss from governments' actions, such as from changes in tax laws or
environmental regulations or the expropriation of assets.

13. An investment security with high risk will have a(n)

a. Increasing expected rate of return.
b. The high standard deviation of returns.
c. Lower price than an asset with low risk.
d. Low expected return.
ANS: B
The greater the standard deviation of the expected return, the riskier the investment. A large standard
deviation implies that the range of possible returns is wide; i.e., the probability distribution is broadly
dispersed. Conversely, the smaller the standard deviation, the tighter the probability distribution and the
lower the risk.

14. Deed Co. owns 2% of Beck Cosmetic Retailers. A property dividend by Beck consisted of merchandise
with a fair value lower than the listed retail price. Deed, in turn, gave the merchandise to its employees as
a holiday bonus. How should Deed report the receipt and distribution of the merchandise in its statement
of cash flows?
a. As both an inflow and outflow for investing activities.
b. As an inflow for investing activities and outflow for operating activities.
c. As both an inflow and outflow for operating activities.
d. As a noncash activity.
ANS: D
Noncash transactions should be excluded from the statement of cash flows to achieve the statement's
objectives better. However, information about noncash investing and financing transactions must be
reported in related disclosures.
 Investment Risk and Portfolio Management

15. On March 1, year 1, Acadia purchased 1,000 shares of the common stock of Marston Corp. for P50,000
and classified the investment as available-for-sale securities. On December 31, year 1, the Marston stock
had a fair value of P53,000. Acadia Corp. prepares its financial statements by PFRS. Acadia elects to use
fair value through profit or loss to record its investments in available-for-sale securities. How is the gain
on the investment in Marston stock reported in Acadia's year one financial statement?
a. As a P3,000 gain in current earnings of the period.
b. As a P3,000 gain in other comprehensive income.
c. No gain or loss is reported in year 1.
d. As a P3,000 prior period adjustment to retained earnings.
ANS: A
The requirement is to identify how the gain is reported. PFRS requires that if an asset is classified as fair
value through profit or loss, it is remeasured to fair value, and any profit or loss is recorded in the period.
Therefore, Acadia should recognize a P3,000 gain in the current earnings of the period.

16. A measure that describes the risk of an investment project relative to other investments, in general, is the
a. Coefficient of variation.
b. Standard deviation.
c. Beta coefficient.
d. Expected return.
ANS: C
The required rate of return on equity capital in the capital asset pricing model is the risk-free rate
(determined by government securities), plus the product of the market risk premium times the beta
coefficient beta measures the firm’s risk. The market risk premium is the amount above the risk-free rate
that will induce investment in the market. The beta coefficient of an individual stock is the correlation
between the volatility (price variation) of the stock market and the individual stock price. For example, if
an individual stock goes up 15% and the market only 10%, beta is 1.5.

17. The incremental benefits of portfolio diversification initially decrease as the number of different securities
held increases. The benefits become extremely small when more than about __________ different
securities are held.
a. 30 to 40.
b. 20 to 30.
c. 40 to 50.
d. 10 to 20.
ANS: B
In principle, diversifiable risk should continue to decrease as the number of different securities held
increases. However, in practice, diversification benefits become extremely small when more than 20 to 30
different securities are held.

18. The risk of a single stock is

a. Market risk.
b. Security risk.
c. Portfolio risk.
d. Interest rate risk.
ANS: B
 Investment Risk and Portfolio Management

The security risk is the risk of a single stock, whereas portfolio risk is its risk if held in a large portfolio of
diversified securities. Portfolio risk, therefore, includes diversifiable and undiversifiable risks.

19. Using the capital asset pricing model (CAPM), the required rate of return for a firm with a beta of 1.25
when the market return is 14%, and the risk-free rate is 6% is
a. 16.0%
b. 6%
c. 17.5%
d. 7.5%
ANS: A
The CAPM adds the risk-free rate to the beta coefficient product and the difference between the market
return and the risk-free rate. The market risk premium is the amount above the risk-free rate for which
investors must be compensated to induce them to invest in the company. An individual stock's beta
coefficient is the correlation between the volatility (price variation) of the stock market and the volatility
of the individual stock price. Thus, the required rate is 16% [6% + 1.25 (14% / 6%)]

20. Under PFRS, an equity investment may be accounted for using the equity method if the investor has
significant influence over the investee. Significant influence is indicated by ownership of
a. More than 50%.
b. From 20 to 50%.
c. More than 70%.
d. At least 10%.
ANS: B
The requirement is to identify the percentage of ownership that indicates significant influence under
PFRS. The percentage is from 20 to 50%.

21. A company purchased bonds at a discount on the open market as an investment and intends to hold these
bonds to maturity. The company does not elect the fair value option for the bonds. The company should
account for these bonds at
a. lower of cost or market.
b. Amortized cost.
c. Fair value
d. Cost
ANS: B
Held-to-maturity securities, which include only debt securities, are reported on the balance sheet at
amortized cost without fair value adjustment. Suppose the investment in bonds had been classified as
trading or available-for-sale.

Trading securities are reported at fair value, with holding gains or losses flowing through the income
statements. Available-for-sale securities are reported at fair value, holding gains or losses reported as a
component of other comprehensive income. Cost and lower cost or market are not used as reporting bases
for bond investments.
 Investment Risk and Portfolio Management

22. When purchasing temporary investments, which one of the following best describes the risk associated
with selling the investment in a short period without significant price concessions?
a. Liquidity risk.
b. Financial risk.
c. Purchasing-power risk.
d. Interest-rate risk
ANS: A
Liquidity risk is the possibility that an asset cannot be sold on short notice for its market value. If an asset
must be sold at a high discount, it is said to have substantial liquidity risk.

23. The benefits of diversification decline to near zero when the number of securities held increases beyond
a. 4
b. 10
c. 40
d. 6
ANS: C
The benefits of diversification become extremely small when more than 20 to 30 different securities are
held. Moreover, commissions and other transaction costs increase with greater diversification.

24. Systematic risk explains why

a. Stock values move in different directions.
b. Diversification increases overall risk.
c. Stock values tend to move in the same direction.
d. Diversification reduces overall risk.
ANS: C
Systematic risk, also called market risk, is the risk faced by all firms. Changes in the economy as a whole,
such as the business cycle, affect all players in the market. Since all firms are affected by systematic risk,
all of their stock values move somewhat in the same direction.

25. Portfolio XYZ is well diversified. It has a return of 10.5%, a portfolio beta of 1.2, and a standard
deviation of 5%. Assume the risk-free rate is 3% and the interest rate on long-term government bonds is
6%. What is the Treynor measure of the portfolio?
a. 1.5
b. 6.25
c. 1.2
d. 0.9
ANS: B
Treynor measure is calculated by dividing the excess portfolio return (i.e., portfolio return minus risk-free
rate) by the portfolio beta.
 Investment Risk and Portfolio Management

26. Portfolio XYZ is well diversified. It has a return of 10.5%, a portfolio beta of 1.2, and a standard
deviation of 5%. Assume the risk-free rate is 3% and the interest rate on long-term government bonds is
6%. What is the Sharpe measure of the portfolio?
a. 0.9
b. 1.5
c. 6.25
d. 1.2
ANS: B
Sharpe measure is calculated by dividing the portfolio excess return (i.e., portfolio return minus risk-free
rate) by the portfolio's standard deviation.

27. The risk that securities cannot be sold at a reasonable price on short notice is called
a. Purchasing-power risk.
b. Default risk.
c. Liquidity risk.
d. Interest-rate risk.
ANS: C
An asset is liquid if it can be converted to cash on short notice. Liquidity (marketability) risk is the risk
that assets cannot be sold at a reasonable price on short notice. If an asset is not liquid, investors will
require a higher return than for a liquid asset. The difference is the liquidity premium.

28. For the last ten years, Woody Co. has owned cumulative preferred stock issued by Hadley, Inc. During
year 2, Hadley declared and paid both the year two dividend and the year one dividend in arrears. How
should Woody report the year one dividend in arrears that was received in year 2?
a. As a retroactive change of the prior period financial statements.
b. Include in year two income from continuing operations.
c. Include net income taxes after year two income from continuing operations.
d. As a reduction in cumulative preferred dividends receivable.
ANS: B
Dividends in arrears are not receivable to the cumulative preferred stockholder until the issuing
corporation’s board of directors formally declares the dividend. In this case, Hadley, Inc. did not declare
the year one dividends in arrears until year 2. At the year two dividend declaration date, Woody Co.
records dividends receivable and dividend income. Dividend income is included in income from
continuing operations.

29. The difference between the required rate of return on a given risky investment and that on a riskless
investment with the same expected utility is the
a. Coefficient of variation.
b. Standard deviation.
c. Risk premium.
d. Beta coefficient.
ANS: C
 Investment Risk and Portfolio Management

The required rate of return on equity capital in the capital asset pricing model is the risk-free rate
(determined by government securities) plus the product of the market risk premium times the beta
coefficient (beta measures the firm’s risk. The market risk premium is the amount above the risk-free rate
that will induce investment in the market. The beta coefficient of an individual stock is the correlation
between the volatility (price variation) of the stock market and the individual stock price.

30. Listed below are four numbers. Which of these numbers represents the coefficient of correlation of a
stock portfolio with the least risk?
a. -1.0
b. 0.0
c. 1.0
d. 100.0
ANS: A
The correlation coefficient measures the degree to which any two variables, e.g., two stocks in a portfolio,
are related. A perfect negative correlation (1.0) means that the two variables always move in the opposite
direction. Given perfect negative correlation, the risk would, in theory, be eliminated. In practice, the
existence of market risk makes perfect correlation all but impossible.

31. An automobile company that uses the futures market to set the price of steel to protect a profit against
price increases is an example of
a. Selling futures to protect against price declines.
b. Selling futures to protect the company from loss.
c. A short hedge.
d. A long hedge.
ANS: D
A change in prices can be minimized or avoided by hedging. Hedging is the process of using offsetting
commitments to reduce or prevent the impact of adverse price movements. The automobile company
desires to stabilize the price of steel so that its cost to the company will not rise and cut into profits.
Accordingly, the automobile company uses the futures market to create a long hedge; a futures contract
purchased to protect against price increases.

32. In its financial statements, Pulham Corp. uses the equity method of accounting for its 30% ownership of
Angles Corp. On December 31, year 1, Pulham has a receivable from Angles. How should the receivable
be reported in Pulham's year one financial statement?
a. The total receivable should be disclosed separately.
b. 70% of the receivable should be separately reported, with the balance offset against 30%
of Angles? Payable to Pulham.
c. None of the receivables should be reported, but the entire receivable should be offset
against Angles’ payable to Pulham.
d. The total receivable should be included as part of the investment in Angles, without
separate disclosure.
ANS: A
 Investment Risk and Portfolio Management

The equity method is used when accounting for investments in which the investor can exercise significant
influence over the investee's operating and financial policies. Ownership of 20% or more of the
outstanding common stock demonstrates this ability. In this case, Pulham Corp. owns 30% of Angles and
properly uses the equity method. Under the equity method, intercompany profits and losses are
eliminated. However, receivables and payables are not eliminated as they are in the case of consolidated
financial statements. On the December 31, year one balance sheet, Pulham should separately disclose the
receivable's total amount. Additionally, this receivable should be shown separately from other
receivables.

33. Under PFRS, investments are classified in any of the following different ways, except
a. Available for sale.
b. Fair value through profit and loss.
c. Tradable.
d. Held to maturity.
ANS: C
The requirement is to identify the item that does not represent a category of investments under PFRS.
PFRS includes fair value classifications through profit and loss, held to maturity, and available for sale. It
does not have tradable.

34. A company purchased bonds at a discount on the open market as an investment and intends to hold these
bonds to maturity. Assume that the company elects the fair value option. The company should account for
these bonds at
a. Lower cost or market.
b. Cost.
c. Amortized cost.
d. Fair value.
ANS: D
A company may elect to value held-to-maturity securities at fair value. Any increase or decrease in value
is reported as a gain or loss and included in earnings for the period.

35. Political risk may be reduced by

a. Making foreign operations dependent on the domestic parent for technology, markets, and
supplies.
b. Entering into a joint venture with another foreign company.
c. Refusing to pay higher wages and higher taxes.
d. Financing with capital from a foreign country.
ANS: A
Political risk is the risk that a foreign government may act to reduce its investment value. Political risk
may be reduced by making foreign operations dependent on the domestic parent for technology, markets,
and supplies.
 Investment Risk and Portfolio Management

36. A company have extra cash at the end of the year and analyze the best way to invest them. The company
should invest in a project only if the
a. Return on investments of the comparable risk exceeds the expected return on the project.
b. The expected return on the project exceeds the return on investments of comparable risk.
c. Return on investments of comparable risk equals the expected return on the project.
d. The expected return on the project is equal to the return on investments of comparable
risk.
ANS: B
Investment risk is analyzed in terms of the probability that the actual return on an investment will be
lower than the expected return. Comparing a project’s expected to return with the return on an asset of
similar risk helps determine whether the project is worth investing in. If the expected return on a project
exceeds the return on an asset of comparable risk, it should be pursued.

37. If two projects are completely and positively linearly dependent (or positively related), the measure of the
correlation between them is
a. +1
b. -1
c. 0
d. +0.5
ANS: A
The measure of correlation when two projects are linearly dependent in a positive way will be +1.0.

38. The risk of loss because of fluctuations in the relative value of foreign currencies is called
a. undiversifiable risk.
b. Multinational beta.
c. Exchange rate risk.
d. Expropriation risk.
ANS: C
When amounts to be paid or received are denominated in a foreign currency, exchange rate fluctuations
may result in exchange gains or losses. For example, suppose a Philippine firm has a receivable fixed in
terms of foreign currency units. In that case, a decline in the value of that currency relative to the
Philippine peso results in a foreign exchange loss.

39. Under PFRS, any investment may be accounted for by fair value through profit and loss, providing
a. It is an equity instrument.
b. It is a debt instrument
c. It is traded in an active market.
d. The instrument matures within two years.
ANS: C
The requirement is to identify for an investment to be accounted for using fair value through profit and
loss. The investment must be traded in an active market for fair value through profit and loss.
 Investment Risk and Portfolio Management

40. Which of the following specific measures volatility returns together with their correlation with other
securities' returns?
a. Variance.
b. Coefficient of variation.
c. Standard deviation.
d. Covariance.
ANS: D
An important measurement used in portfolio analysis is covariance. It measures the volatility of returns
together with their correlation with the returns of other securities. For two stocks X and Y, the covariance
is calculated using the following formula: Coefficient of correlation x Standard Deviation X x Standard
Deviation Y

41. Which one of the following would have the least impact on a firm's beta value?
a. Operating leverage.
b. Debt-to-equity ratio.
c. Payout ratio.
d. Industry characteristics.
ANS: C
The payout ratio is the percentage of income available to common shareholders paid out in dividends
during a period. The payout ratio is more nearly the result, rather than the cause, of a firm’s beta value.
The beta value is based on the volatility of a company’s earnings. Volatility is influenced by financial and
operating leverage and the industry's characteristics in which the firm operates.

42. If a company has a beta value of 1.0, then its

a. Volatility is low.
b. Price is relatively stable.
c. The expected return should approximate the overall market.
d. The return should equal the risk-free rate.
ANS: C
The effect of individual security on a portfolio's volatility is measured by its sensitivity to the overall
market's movements. This sensitivity is stated in terms of a stock’s beta coefficient. If the beta coefficient
is 1.0, then the stock price tends to move in the same direction and the same degree as the overall market.

43. Under PFRS, if a company uses the fair value method for accounting for investment, any changes in fair
value are recognized in
a. Other comprehensive income.
b. Revaluation surplus.
c. Profit and loss.
d. Retained earnings.
ANS: C
The requirement is to identify how fair value changes are recognized for an investment accounted for
under PFRS. Gains or losses are recognized in profit and loss of the period.
 Investment Risk and Portfolio Management

44. In theory, which of the following coefficients of correlation would eliminate risk in an investment
portfolio?
a. 0.0
b. No theoretical coefficient exists for the elimination of risk in a portfolio context.
c. -1.0
d. 1.0
ANS: C
The correlation coefficient measures the degree to which any two variables, e.g., two stocks in a portfolio,
are related. A perfect negative correlation (1.0) means that the two variables always move in the opposite
direction. Given perfect negative correlation, the risk would, in theory, be eliminated. In practice, the
existence of market risk makes perfect correlation all but impossible.

45. In the context of the capital asset pricing model (CAPM), the beta coefficient of a stock that has the same
systematic risk as the market as a whole is equal to
a. -1
b. 1
c. 0.5
d. 0
ANS: B
A beta of 1 indicates that the stock return has an identical change for every change in the market return;
thus, they have the same systematic risk.

46. Deed Co. owns 2% of Beck Cosmetic Retailers. A property dividend by Beck consisted of merchandise
with a fair value lower than the listed retail price. Deed, in turn, gave the merchandise to its employees as
a holiday bonus. How should Deed report the receipt and distribution of the merchandise in its income
statement?
a. At the listed retail price for both dividend revenue and employee compensation expense.
b. By disclosure only.
c. At fair value for dividend revenue and listed retail price for employee compensation
expense.
d. At fair value for both dividend revenue and employee compensation expense.
ANS: D
A nonmonetary asset (the merchandise in this case) received in a nonreciprocal transfer should be
recorded at the fair value of the asset received. Additionally, the transfer of a nonmonetary asset to a
stockholder or other entity (Deed’s employees in this case) should be recorded at the fair value of the
asset received.

47. If other factors remain constant, for an investment-grade corporate bond, the higher its liquidity, the:
a. lower its yield to maturity.
b. longer its duration.
c. lower its default risk.
d. higher its coupon rate.
ANS: A
Higher liquidity leads to a lower liquidity premium, hence a lower required rate of return, which causes
higher prices. Therefore, the bond yield will be lower.
 Investment Risk and Portfolio Management

48. The type of risk that is not diversifiable and affects the value of a portfolio is
a. Nonmarket risk
b. Interest-rate risk.
c. Purchasing-power risk.
d. Market risk.
ANS: D
Prices of all stocks, even the value of portfolios, are correlated to some degree with broad swings in the
stock market. Market risk is the risk that changes in a stock's price will result from changes in the stock
market as a whole. Market risk is commonly referred to as non diversifiable risk.

49. Which of the following is the major difference between the capital asset pricing model (CAPM) and
arbitrage pricing theory (APT)?
a. CAPM uses a single systematic risk factor to explain an asset’s return, whereas APT uses
multiple systematic factors.
b. Under CAPM, the beta coefficient of the risk-free rate of return is assumed to be higher
than that of any asset in the portfolio. Under APT, the beta coefficient of every asset in the
portfolio is individually compared to the beta of the risk-free rate.
c. CAPM uses discounted cash flows, whereas APT does not.
d. APT uses a single systematic risk factor to explain an asset’s return, whereas CAPM uses
multiple systematic factors.
ANS: A
CAPM uses a single systematic risk factor to explain an asset’s return, whereas APT uses multiple
systematic factors.

50. A company’s, a small but growing product assembler, has profitably ridden the ups and downs of several
economic cycles, largely due to its low level of long-term assets. The firm relies more heavily on labor
than its competitors and contracts for needed facilities only on a short-term lease basis. Working capital is
largely provided through short-term loans. Although the company’s variable costs are much higher than
its competitors’ variable costs, its income is much less volatile. All of the above factors are consistent
with Redimaker having a lower level of financial and operating
a. Liquidity
b. Solvency
c. Leverage.
d. Margin
ANS: C
Operating leverage measures the level of fixed costs and the firm's degree of risk in its ongoing daily
operations.

51. Band Co. uses the equity method to account for its investment in Guard, Inc. common stock. How should
Band record a 2% stock dividend received from Guard?
a. As dividend revenue at the market value of the stock.
b. As dividend revenue at Guard's carrying value of the stock.
c. As a memorandum entry reducing the unit cost of all Guard stock owned.
d. As a reduction in the total cost of Guard stock owned.
 Investment Risk and Portfolio Management

ANS: C
Stock dividends are not income to the recipient but rather adjust the per-share basis of the investment.

52. Deed Co. owns 2% of Beck Cosmetic Retailers. A property dividend by Beck consisted of merchandise
with a fair value lower than the listed retail price. Deed, in turn, gave the merchandise to its employees as
a holiday bonus. How should Deed report the receipt and distribution of the merchandise in its statement
of cash flows?
a. As an inflow for investing activities and outflow for operating activities.
b. As both an inflow and outflow for investing activities.
c. As a noncash activity.
d. As both an inflow and outflow for operating activities.
ANS: C
Noncash transactions should be excluded from the statement of cash flows to achieve the statement's
objectives better. However, information about noncash investing and financing transactions must be
reported in related disclosures.

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