SIE Understanding Products and Their Risks Question 33: Answer and Explanation

Question: 33

Which of the following is considered difficult to mitigate in the short term through diversification, portfolio rebalancing, or hedging?

• A. Political/geopolitical risk
• B. Prepayment risk
• C. Market/systematic risk
• D. Non-systematic risk

Correct Answer: C

Explanation:

C: Market risk, also known as systematic risk, is related to the value of most securities changing in the general direction of the market, with the change not related to characteristics of each specific security. This risk is more apparent when economic or political uncertainty increases. Market risk is generally considered to be difficult to manage in the short term using strategies such as diversification, portfolio rebalancing, or hedging, which are typically considered effective to help manage non-systematic, non–market-related risks. A strategy for mitigating political/geopolitical risk, Choice A, could include diversification among various countries. A strategy for mitigating prepayment risk, Choice B, could include diversification among maturity dates, types of debt instruments, and a sheer quantity of debt investments, as is available in a diversified mutual or ETF bond fund. Choice D, non-systematic risk, covers a wide variety of risks other than market risk, including capital risk, credit risk, currency risk, inflationary/purchasing power risk, interest rate/reinvestment risk, liquidity risk, as well as political/geopolitical risk, Choice A, and prepayment risk, Choice B. These are generally considered to be lessened through the use of diversification as well as portfolio rebalancing and hedging.