D.35 Alternative investments and liquidity risk Flashcards
(26 cards)
A client invested in a private equity fund that has a 10-year lock-up period. After five years, the client wants to withdraw funds due to unexpected expenses. What is the liquidity risk associated with this investment?
A) Liquidity risk is low because the investment has a defined lock-up period.
B) Liquidity risk is high because the client may not be able to withdraw funds before the lock-up period ends.
C) Liquidity risk is moderate because the client can sell the investment to another investor.
D) Liquidity risk is negligible because the private equity fund is considered a low-risk investment.
Liquidity risk is high because the client may not be able to withdraw funds before the lock-up period ends
Explanation: Private equity funds often have a long lock-up period, during which investors cannot withdraw their funds. This means that investors may face liquidity risk if they need to access their funds before the end of the lock-up period.
D.35 Alternative investments and liquidity risk
What is the primary liquidity risk associated with investments in private equity funds?
A) Counterparty risk
B) Market risk
C) Funding risk
D) Lock-up risk
Lock-up risk
Explanation: Private equity funds typically require investors to commit their funds for several years, during which they cannot redeem their investments. This illiquidity poses a lock-up risk to investors, which is the primary liquidity risk associated with private equity funds.
D.35 Alternative investments and liquidity risk
Which of the following alternative investments is most likely to be impacted by a sudden change in interest rates?
A) Hedge funds
B) Real estate investment trusts (REITs)
C) Private equity funds
D) Commodities
Real estate investment trusts (REITs)
Explanation: REITs invest primarily in real estate, and their returns are largely dependent on rental income and property values. Higher interest rates increase borrowing costs for REITs, reducing their profitability and potentially impacting the liquidity of the underlying real estate investments.
D.35 Alternative investments and liquidity risk
Which of the following alternative investments provides the greatest diversification benefits to a portfolio of traditional assets?
A) Private equity funds
B) Commodities
C) Hedge funds
D) Real estate investment trusts (REITs)
Commodities
Explanation: Commodities provide diversification benefits to a portfolio of traditional assets because their returns are generally uncorrelated with the returns of stocks and bonds. This can help reduce overall portfolio risk and volatility.
D.35 Alternative investments and liquidity risk
Which of the following is a potential downside of investing in hedge funds?
A) Limited liquidity
B) High management fees
C) Low potential returns
D) Low risk
High management fees
Explanation: Hedge funds typically charge high management fees and performance fees, which can eat into investor returns. Additionally, some hedge funds may have limited liquidity, making it difficult for investors to withdraw their funds if needed.
D.35 Alternative investments and liquidity risk
John is an individual investor looking to diversify his portfolio with alternative investments. He is interested in investing in a hedge fund. Which of the following risks is most closely associated with hedge funds?
A) Market risk
B) Credit risk
C) Interest rate risk
D) Liquidity risk
Liquidity risk
Explanation: Hedge funds typically have longer lock-up periods, meaning that investors cannot redeem their shares for a certain period of time. This can create liquidity risk for the investor, as they may not be able to access their funds when they need to.
D.35 Alternative investments and liquidity risk
ABC Company is considering investing in a private equity fund that invests in start-ups. Which of the following risks is most likely to be associated with this investment?
A) Interest rate risk
B) Market risk
C) Credit risk
D) Liquidity risk
Market risk
Explanation: Private equity investments are typically long-term and illiquid, but the primary risk associated with these investments is market risk. Start-up companies are inherently risky, and the value of the investment can be highly dependent on the success of the start-up.
D.35 Alternative investments and liquidity risk
Sarah is an institutional investor considering investing in a real estate fund that invests in commercial properties. Which of the following risks is most likely to be associated with this investment?
A) Interest rate risk
B) Credit risk
C) Market risk
D) Liquidity risk
Liquidity risk
Explanation: Real estate investments can be highly illiquid, especially when investing in commercial properties. Investors may not be able to sell their shares quickly, which creates liquidity risk.
D.35 Alternative investments and liquidity risk
Tom is an individual investor looking to invest in a fund that specializes in investing in art. Which of the following risks is most likely to be associated with this investment?
A) Credit risk
B) Interest rate risk
C) Market risk
D) Liquidity risk
Market risk
Explanation: Art investments can be highly speculative and can be subject to fluctuations in the market. If the demand for a particular type of art decreases, the value of the investment can decrease as well.
D.35 Alternative investments and liquidity risk
A client is considering investing in a private equity fund that has a 10-year lock-up period. What is the primary liquidity risk associated with this investment?
A) The fund’s performance may not meet expectations.
B) The client may need access to their capital before the lock-up period expires.
C) The fund may not be able to meet redemption requests in a timely manner.
D) The fund may charge high fees that erode returns.
The primary liquidity risk associated with a 10-year lock-up period is that the client may need access to their capital before the lock-up period expires.
Explanation: Private equity funds are illiquid investments, which means that investors typically cannot redeem their shares until the lock-up period ends. If the client needs access to their capital before the lock-up period expires, they may have to sell their shares on the secondary market at a discount.
D.35 Alternative investments and liquidity risk
A client is interested in investing in a private equity fund. What is a significant liquidity risk associated with this type of investment?
A) The private equity fund’s investments may be illiquid
B) The private equity fund may have a high expense ratio
C) The private equity fund may have a low return
D) The private equity fund’s investments may be too risky
The private equity fund’s investments may be illiquid
Explanation: Private equity funds invest in companies that are not publicly traded, which makes it challenging to buy and sell shares. This lack of liquidity can lead to longer holding periods and difficulty in accessing cash quickly.
D.35 Alternative investments and liquidity risk
A client is considering investing in a real estate investment trust (REIT). What is a significant liquidity risk associated with this type of investment?
A) The REIT’s investments may be illiquid.
B) The REIT may have a high expense ratio.
C) The REIT may have a low return.
D) The REIT’s investments may be too risky.
The REIT’s investments may be illiquid
Explanation: REITs invest in real estate properties, which may not be easily liquidated. This illiquidity can be particularly challenging during a market downturn when there is a lack of buyers for real estate assets.
D.35 Alternative investments and liquidity risk
What type of liquidity risk is associated with private equity investments?
A) Market liquidity risk
B) Funding liquidity risk
C) Asset liquidity risk
D) Reinvestment liquidity risk
Asset liquidity risk
Explanation: Private equity investments are typically illiquid as they involve investing in privately held companies or assets that may not be easily sold. Asset liquidity risk is the risk of not being able to sell an asset at a fair price or in a timely manner.
D.35 Alternative investments and liquidity risk
Which of the following alternative investments has the lowest liquidity risk?
A) Hedge funds
B) Private equity
C) Real estate
D) Commodities
Commodities
Explanation: Commodities are highly liquid assets, as they can be easily bought or sold on commodities exchanges. Hedge funds, private equity, and real estate investments are typically illiquid and have higher liquidity risk.
D.35 Alternative investments and liquidity risk
A hedge fund manager uses leverage to increase returns. What type of liquidity risk is the manager exposed to?
A) Funding liquidity risk
B) Market liquidity risk
C) Asset liquidity risk
D) Systemic liquidity risk
Funding liquidity risk
Explanation: Leverage involves borrowing money to invest, which increases the fund’s exposure to funding liquidity risk, or the risk of not being able to raise enough cash to meet obligations.
D.35 Alternative investments and liquidity risk
A private equity firm invests in a startup with a high potential for growth but limited cash flow. What type of liquidity risk is the firm exposed to?
A) Funding liquidity risk
B) Market liquidity risk
C) Asset liquidity risk
D) Reinvestment liquidity risk
Reinvestment liquidity risk
Explanation: Reinvestment liquidity risk is the risk that an investment cannot be reinvested at a fair price or rate of return. In this scenario, the private equity firm may have difficulty exiting the investment and reinvesting the proceeds in other opportunities.
D.35 Alternative investments and liquidity risk
An investor invests in a hedge fund that invests in complex derivatives. What type of liquidity risk is the investor exposed to?
A) Funding liquidity risk
B) Market liquidity risk
C) Asset liquidity risk
D) Systemic liquidity risk
Market liquidity risk
Explanation: Hedge funds often invest in illiquid securities, such as complex derivatives, which can make it difficult to exit positions quickly. This exposes investors to market liquidity risk, or the risk of not being able to sell the investment at a fair price due to market conditions.
D.35 Alternative investments and liquidity risk
A pension fund invests in a private equity fund that buys distressed companies. What type of liquidity risk is the pension fund exposed to?
A) Funding liquidity risk
B) Market liquidity risk
C) Asset liquidity risk
D) Reinvestment liquidity risk
Asset liquidity risk
Explanation: Private equity investments typically involve investing in privately held companies or assets that may not be easily sold. The pension fund is exposed to asset liquidity risk, or the risk of not being able to sell the investment at a fair price or in a timely manner.
D.35 Alternative investments and liquidity risk
A family office invests in a real estate development project that is expected to take several years to complete. What type of liquidity risk is the family office exposed to?
A) Funding liquidity risk
B) Market liquidity risk
C) Asset liquidity risk
D) Systemic liquidity risk
Asset liquidity risk
Explanation: Real estate development projects are typically illiquid and may take years to complete. The family office is exposed to asset liquidity risk, or the risk of not being able to sell the investment at a fair price or in a timely manner.
D.35 Alternative investments and liquidity risk
A high-net-worth investor invests in a fund that specializes in distressed debt. What type of liquidity risk is the investor exposed to?
A) Funding liquidity risk
B) Market liquidity risk
C) Asset liquidity risk
D) Systemic liquidity risk
Asset liquidity risk
Explanation: Distressed debt investments may be illiquid, as it can be difficult to sell these types of securities quickly or at a fair price. The investor is exposed to asset liquidity risk.
D.35 Alternative investments and liquidity risk
A CFP professional’s client anticipates that a publicly traded company’s common stock will rise significantly in the next few months. The client is low on cash and must wait for a CD to mature before they can purchase the shares. Which of the following strategies should the CFP professional suggest?
A) Advise the client to take out a margin loan against their existing investment portfolio to buy the company’s stock immediately.
B) Recommend the client to wait for the CD to mature and then use the proceeds to purchase the stock.
C) Suggest the client explore options trading to potentially profit from the stock’s anticipated rise without immediate cash outlay.
D) Encourage the client to sell some of their existing investments to raise cash for purchasing the stock.
Suggest the client explore options trading to potentially profit from the stock’s anticipated rise without immediate cash outlay.
Explanation Options trading, such as buying call options, allows for leveraged exposure to the stock’s price movement, and the client can decide whether to exercise the option or not when their CD matures. Options can provide flexibility and potential gains without the need to sell existing investments or take on margin debt. Option A could be risky with potential margin calls, Option B may result in missed opportunities, and Option D could lead to capital gains taxes and selling at unfavorable prices.
D.35 Alternative investments and liquidity risk
Sarah, a client with accredited investor status, believes that stock market prices will surge in the coming year. Which of the following investment strategies is the most appropriate for Sarah?
A) Sell an index call and buy an index put
B) Sell a money market fund and buy an index call
C) Sell an index call and sell an index put
D) Sell a money market fund and buy an index put
Sell an index call and buy an index put
Explanation: Selling an index call allows Sarah to earn premium income, but it also obligates her to potentially sell the index at a specific price (the strike price) if the market rises significantly. However, buying an index put gives her the right to sell the index at a predetermined price, providing a hedge against potential losses in case the market falls. This combination of strategies (selling a call and buying a put) is known as a “covered call protective put” or a “collar” and is a suitable strategy for an accredited investor like Sarah who is bullish on the market but wants to protect against downside risk.
D.35 Alternative investments and liquidity risk
Jane, a CFP professional, is advising her client, Mark. Mark purchased 1,000 shares of a particular stock at $9 per share. Currently, this stock is trading at $39 per share. Mark is optimistic about the stock’s future performance and believes it will continue to appreciate. However, he also wants to safeguard his existing profits. Which of the following strategies would be the MOST appropriate for Jane to recommend to Mark?
A) Immediately place a market order to sell 770 shares.
B) Short sell 1,000 shares and write ten $20 calls at $3.
C) Short sell 1,000 shares and buy ten $45 calls at $1.
D) Buy ten $20 puts at $2.
Buy ten $20 puts at $2.
Explanation: By purchasing puts, the client is buying the right, but not the obligation, to sell the stock at the strike price of the put option before the option’s expiration. In this case, the strike price is $20. If the stock price falls below $20, the client can exercise the put option and sell the stock at the $20 strike price, thereby protecting the majority of his profits. This strategy allows Mark to continue benefiting from any potential upside (if the stock continues to rise) while also offering a safety net should the stock’s value decline.
D.35 Alternative investments and liquidity risk
Jane, a CFP professional, is advising her client, Mark. Mark purchased 1,000 shares of a particular stock at $9 per share. Currently, this stock is trading at $39 per share. Mark is optimistic about the stock’s future performance and believes it will continue to appreciate. However, he also wants to safeguard his existing profits. Which of the following strategies would be the LEAST appropriate for Jane to recommend to Mark?
A) Immediately place a market order to sell 770 shares.
B) Short sell 1,000 shares and write ten $20 calls at $3.
C) Short sell 1,000 shares and buy ten $45 calls at $1.
D) Buy ten $20 puts at $2.
Short sell 1,000 shares and write $20 calls at $3.
Explanation: Short selling 1,000 shares would be like betting against the stock, as you’re hoping for its price to decrease. Additionally, writing $20 calls would mean you’re obligated to sell the stock at $20 if the option is exercised. This makes no sense when the stock is currently at $39 and the client believes the stock will continue to rise. Both components of this strategy are counterintuitive and expose the client to unnecessary risk. The other options help in some form or another to protect profits or hedge against potential declines.
D.35 Alternative investments and liquidity risk
