HKSI Licensing Examination Paper 8 (Securities) — All Questions

The risk-return trade-off principle states that:

• a.To seek higher expected returns, an investor must generally accept higher risk✓
• b.Lower-risk assets always deliver the highest returns
• c.Higher expected returns can reliably be earned while taking on progressively lower levels of investment risk
• d.Risk and return are entirely unrelated

Investors will only take on more risk if they expect to be compensated with higher returns. Consequently, assets offering higher potential returns typically carry greater risk of loss, and vice versa.

Systematic risk is best described as risk that:

• a.Is simply another name for credit risk
• b.Can be diversified away entirely simply by holding a large enough number of different shares in the portfolio
• c.Is market-wide, arising from factors such as interest rates or recession, and cannot be removed by diversification✓
• d.Affects only one individual company

Systematic (market) risk stems from economy-wide factors that affect nearly all assets, so spreading investments across many holdings cannot eliminate it. Only unsystematic, company-specific risk can be diversified away.

Unsystematic (specific) risk is:

• a.Risk specific to a single company or sector that can be reduced by holding a diversified portfolio✓
• b.Risk that arises from economy-wide factors and therefore can never be reduced no matter how much one diversifies
• c.Market-wide risk affecting all assets
• d.Simply the risk-free rate of return

Unsystematic risk arises from factors unique to a firm or industry, such as a product failure or management change. Because such events are largely independent across companies, holding many securities diversifies it away.

Credit (default) risk is:

• a.The risk that a bond issuer fails to pay interest or repay principal when due✓
• b.The risk that the general level of share prices across the whole market falls and reduces the value of a holding
• c.The risk that inflation rises
• d.The risk that exchange rates move

Credit risk is the danger that a borrower cannot meet its obligations. For a bondholder this means missed coupons or a failure to repay principal, which is why weaker issuers must pay higher yields.

Liquidity risk refers to:

• a.The risk that a bond issuer defaults
• b.The risk that inflation erodes returns
• c.The risk of not being able to sell an asset quickly without accepting a lower price✓
• d.The risk that a rise in market interest rates reduces the market value of the investor's fixed-income holdings

Liquidity risk is the difficulty of converting an investment into cash promptly at a fair price. Thinly traded securities may have to be sold at a discount, or cannot be sold quickly at all, when the holder needs the money.

Inflation (purchasing-power) risk is:

• a.The risk that exchange rates move against the investor
• b.The risk that a bond issuer defaults
• c.The risk that rising prices erode the real, purchasing-power value of an investment's returns✓
• d.The risk that a company's own share price falls sharply because of some problem specific to that one business

Even a positive nominal return can lose real value if inflation is high. Fixed-income investors are especially exposed, because their coupons and principal are fixed in nominal terms while prices rise.

Interest-rate risk is:

• a.The risk that changes in market interest rates alter the value of investments, notably fixed-income bonds✓
• b.The risk that the company whose shares are held decides to reduce or completely cancel its dividend payment
• c.The risk of fraud by a broker
• d.The risk of low trading volume in a share

When market rates change, the present value of an asset's future cash flows changes. Bonds are particularly affected: a rise in rates lowers existing bond prices, and longer-dated bonds are the most sensitive.

Currency (exchange-rate) risk is:

• a.The risk of general inflation
• b.The risk that domestic interest rates rise
• c.The risk that a listed company is delisted from the exchange and its shares can no longer be freely traded
• d.The risk that exchange-rate movements reduce the value of an investment denominated in a foreign currency✓

An investor holding foreign-currency assets is exposed to exchange-rate moves: if that currency weakens against the home currency, the value of the investment falls when translated back, regardless of its local performance.

Reinvestment risk is the risk that:

• a.A bond issuer will default on its principal
• b.A broker commits fraud
• c.Coupons or maturing proceeds must be reinvested at lower interest rates than before✓
• d.The risk that the whole stock market falls suddenly and sharply, dragging down the value of most shareholdings

When rates fall, the coupons received and any principal returned can only be reinvested at the new, lower rates, reducing the investor's overall return. Callable bonds heighten this risk, as they are often called when rates drop.

Market risk, as it applies to equities, is:

• a.The same thing as liquidity risk
• b.The risk that a general market decline reduces the value of most shares✓
• c.A risk that can always be removed by diversification
• d.A risk that affects only one particular industry or sector and leaves the rest of the market largely untouched

Market (systematic) risk reflects broad forces, such as recession or a rate shock, that pull most shares down together. Because it is market-wide, diversifying across many shares cannot eliminate it.

An investment returns 7% over a year when inflation is 3%. The approximate real return is:

• a.3%
• b.10%
• c.4%✓
• d.21%

The real return is roughly the nominal return minus inflation: 7% - 3% = 4%. It shows the increase in purchasing power once the effect of rising prices is stripped out.

The total return on an investment is:

• a.The coupon rate that was originally quoted on the bond at the time it was first issued into the market
• b.The capital gain only
• c.The dividend or coupon income only
• d.The sum of income received (dividends or coupons) and any capital gain or loss✓

Total return combines both sources of return: the income received during the holding period plus the change in the asset's price. Measuring only one component understates or overstates the investor's actual result.

An investor buys a share at HK$10, receives a HK$0.50 dividend and sells it at HK$11. The holding-period return is:

• a.15%✓
• b.11%
• c.10%
• d.5%

Holding-period return = (income + capital gain) / cost = (HK$0.50 + HK$1.00) / HK$10 = HK$1.50 / HK$10 = 15%. It captures both the dividend and the price rise.

Capital gain and income return differ in that:

• a.They mean exactly the same thing
• b.A capital gain arises from selling above the purchase price, while income comes from dividends or coupons✓
• c.Income refers to the rise in the share price
• d.A capital gain simply means the dividend income that the shareholder receives while holding onto the share

Income return is the cash yield paid out (dividends on shares, coupons on bonds), whereas a capital gain is the profit from a rise in the asset's price between purchase and sale. Together they form total return.

Dividend yield is:

• a.The share price divided by earnings per share
• b.The total amount of profit that the company earns across the whole of a single financial or accounting year
• c.The coupon rate paid on a bond
• d.The annual dividend expressed as a percentage of the current share price✓

Dividend yield relates the income a shareholder receives to the price paid: annual dividend / share price. It lets investors compare the income return on different shares regardless of their absolute prices.

The distinction between a nominal return and a real return is that:

• a.A real return deliberately ignores the effect of inflation, while a nominal return fully allows for it
• b.A real return is a nominal return adjusted for inflation✓
• c.A nominal return is already adjusted for inflation
• d.They are always exactly equal

The nominal return is the headline percentage before considering inflation. The real return subtracts inflation, showing the true gain in purchasing power, which is what ultimately matters to an investor.

The time value of money means that:

• a.A dollar today is worth more than the same dollar in the future because it can be invested to earn a return✓
• b.Money has no value that depends on timing
• c.A dollar to be received in the future is worth more than one today
• d.Money invariably loses the whole of its value over time, so a sum today is worth nothing at all in the future

Because money in hand can be invested to earn interest, a sum available now is worth more than the same sum later. This principle underlies discounting future cash flows to a present value.

HK$1,000 invested at 5% per year, compounded annually, grows to approximately what after two years?

• a.HK$1,050.00
• b.HK$1,102.50✓
• c.HK$1,150.00
• d.HK$1,100.00

Future value = 1,000 x (1.05)^2 = 1,000 x 1.1025 = HK$1,102.50. The extra HK$2.50 over simple interest is the interest earned on the first year's interest, illustrating compounding.

Using a 10% discount rate, the present value of HK$1,100 to be received in one year is:

• a.HK$1,100
• b.HK$990
• c.HK$1,000✓
• d.HK$1,210

Present value = future amount / (1 + rate) = 1,100 / 1.10 = HK$1,000. Discounting converts a future sum into its equivalent value today at the chosen rate.

The difference between simple and compound interest is that:

• a.Simple interest is earned on interest already accrued
• b.Compound interest is earned on the principal plus previously accumulated interest, so it grows faster✓
• c.They always produce the same result
• d.Simple interest grows an investment faster than compound interest, because interest is not left to accumulate

Simple interest is calculated only on the original principal. Compound interest adds each period's interest to the balance so that future interest is earned on interest as well, accelerating growth over time.

For a given nominal annual rate, more frequent compounding means:

• a.Compounding interest just once a year always produces a higher return than compounding it every single month
• b.The more frequently interest is compounded, the higher the effective annual return✓
• c.Compounding frequency has no effect on the outcome
• d.More frequent compounding reduces the return

Compounding more often lets interest start earning interest sooner, so the effective annual rate exceeds the quoted nominal rate. Monthly compounding therefore yields slightly more than annual compounding at the same nominal rate.

Using the 'rule of 72', roughly how long does money take to double at 6% per year?

• a.12 years✓
• b.18 years
• c.72 years
• d.6 years

The rule of 72 estimates the doubling time by dividing 72 by the annual percentage rate: 72 / 6 = 12 years. It is a quick approximation of compound growth.

The marketability (liquidity) of an investment describes:

• a.The total rate of return, including both income and capital gain, that the investor expects the asset to deliver
• b.How easily and quickly it can be converted into cash at close to its market value✓
• c.Its dividend yield
• d.Its credit rating

A highly marketable asset can be sold rapidly with little price concession, whereas an illiquid one may take time to sell or require a discount. Liquidity affects both risk and the price investors will pay.

The bid-offer (bid-ask) spread is:

• a.The dividend paid on a share
• b.The gap between the price at which an investor can buy (offer) and sell (bid), representing an implicit trading cost✓
• c.The commission the executing broker charges the client for arranging and carrying out the purchase or the sale
• d.A tax levied by the government

Market makers quote a lower bid (buying) price and a higher offer (selling) price; the difference is the spread. An investor effectively pays this spread on a round trip, so wider spreads raise the cost of trading.

When combining securities in a portfolio, correlation matters because:

• a.Correlation has no effect on portfolio risk
• b.Diversification always increases total risk
• c.Combining assets whose returns are perfectly positively correlated with one another reduces portfolio risk the most
• d.Combining assets whose returns are not perfectly positively correlated tends to lower overall portfolio risk✓

If assets do not move perfectly together, losses in one can be offset by gains or stability in another, smoothing overall returns. The lower (or more negative) the correlation, the greater the risk-reduction benefit of diversifying.

An investor whose main objective is income will typically:

• a.Avoid every kind of bond
• b.Prefer non-dividend-paying growth stocks, relying entirely on a future rise in the share price for their return
• c.Seek maximum capital gain and avoid all income
• d.Prefer assets that pay regular income, such as bonds or higher-dividend shares✓

An income-oriented investor values a steady cash flow over capital growth, so gravitates to bonds, high-dividend equities and REITs. Objectives (income, growth, capital preservation) drive the choice of suitable assets.

An investor's risk tolerance is:

• a.The level of risk taken by the broker
• b.The degree of investment risk the investor is willing and able to bear, which guides suitable choices✓
• c.The maximum rate of return that the investor demands before agreeing to commit any money to an investment
• d.The tax the investor must pay on gains

Risk tolerance combines willingness and financial capacity to accept loss. Understanding it is central to suitability: recommendations must match the client's ability and appetite to withstand fluctuations.

A company has 200 million shares in issue trading at HK$15 each. Its market capitalisation is:

• a.HK$1,500 million
• b.HK$3,000 million✓
• c.HK$15 million
• d.HK$200 million

Market capitalisation = number of shares x share price = 200 million x HK$15 = HK$3,000 million (HK$3 billion). It measures the total market value of a company's equity.

Compared with large-cap shares, small-cap shares tend to be:

• a.More volatile and less liquid✓
• b.Always safer and steadier
• c.Traded far less frequently than small-cap shares purely because they are so much larger in overall market value
• d.Unaffected by company size in terms of risk

Smaller companies usually have thinner trading, less diversified businesses and higher earnings variability, so their shares are typically more volatile and harder to trade in size than large-cap shares.

Sustained high inflation affects a conventional fixed-coupon bond by:

• a.Guaranteeing the investor a higher real return
• b.Raising the real, inflation-adjusted value of the fixed coupons the holder receives over the life of the bond
• c.Having no effect on bonds
• d.Eroding the real (purchasing-power) value of its fixed coupon payments✓

A fixed-coupon bond pays the same nominal amount regardless of inflation, so rising prices reduce what those coupons and the returned principal can buy. This is why inflation is a particular concern for bondholders.

When a central bank raises its policy interest rate, the usual effect is that it:

• a.Has no effect on the economy at all
• b.Always immediately boosts share prices, because higher rates make companies more profitable straight away
• c.Directly increases the inflation rate
• d.Tends to raise borrowing costs, slow economic activity and can weigh on asset prices✓

Higher policy rates raise the cost of credit for households and businesses, dampening spending and investment. The higher discount rate and slower growth outlook tend to pressure bond and equity valuations.

A cyclical company is one whose:

• a.A company whose earnings stay completely flat and are unaffected by whether the wider economy grows or shrinks
• b.Income comes from a fixed bond coupon
• c.Earnings rise during economic expansions and fall in downturns✓
• d.Business does best during recessions

Cyclical firms, such as builders or luxury retailers, are sensitive to the economic cycle: their profits swell in boom times and shrink in recessions. This makes their shares more volatile over the cycle than defensive stocks.

Strong GDP growth is generally:

• a.Supportive of corporate earnings and tends to be positive for equities✓
• b.Relevant only to bonds, never to shares
• c.Completely irrelevant to share prices
• d.Certain to lower share prices right across the board, because faster growth always feeds through into inflation

A growing economy usually lifts company revenues and profits, which supports equity valuations. Investors therefore watch GDP and other growth indicators as drivers of the broad market.

'Defensive' stocks are shares in:

• a.Companies with no earnings at all
• b.Companies whose demand is relatively stable through the cycle, such as utilities, that tend to hold up better in downturns✓
• c.Companies that typically collapse and fail during recessions because their sales fall away the most sharply
• d.Fast-growing technology start-ups

Defensive sectors sell essentials whose demand changes little with the economy, so their earnings and share prices are more stable in downturns. They contrast with cyclical stocks, which swing with the cycle.

A yield curve:

• a.Plots the yields of similar bonds against their maturities and is usually upward-sloping✓
• b.Measures the rate of inflation
• c.Shows a company's dividend history
• d.A chart showing a single company's share price plotted continuously over a long historical period of time

The yield curve maps yields for bonds of comparable credit quality across different maturities. Normally it slopes upward, as investors demand more yield to lend for longer; its shape signals expectations about rates and growth.

High-quality government bonds are often used as a benchmark because they:

• a.Actually carry the very highest default risk of all bonds, which is why they are so widely used as a benchmark
• b.Pay no interest to holders
• c.Are regarded as close to risk-free and so serve as a reference for pricing other assets✓
• d.Are actually a form of equity

A creditworthy sovereign is very unlikely to default in its own currency, so its bond yields are treated as a near risk-free rate. Other assets are priced at a spread above this benchmark to reflect their extra risk.

Historically, comparing equities and bonds over the long run:

• a.Equities have produced higher long-run returns than bonds but with greater volatility✓
• b.Bonds have always shown far greater price volatility than equities across every long historical period studied
• c.Equities guarantee a higher return in every single year
• d.Bonds have consistently outperformed equities

Over long periods equities have tended to reward investors with higher returns as compensation for their greater risk, while bonds offer lower but steadier returns. Equity outperformance is not guaranteed in any given year.

Cash and bank deposits, as an asset class, are generally characterised by:

• a.High expected return combined with high risk, making cash deposits one of the most aggressive asset classes
• b.Illiquidity and high risk
• c.Low risk and high liquidity but low return, with exposure to inflation over time✓
• d.A guaranteed ability to beat inflation

Cash offers safety of nominal value and ready access, but its returns are low and can fail to keep pace with inflation, so purchasing power may erode if it is held for long periods.

Ranking the main asset classes from lowest to highest risk, a common ordering is:

• a.Derivatives sit at the very base of the risk pyramid as the lowest-risk of all the main asset classes shown
• b.Equities carry less risk than cash
• c.In ascending order of risk: cash and deposits, then bonds, then equities, then derivatives✓
• d.Bonds are riskier than derivatives

The 'risk pyramid' places cash and deposits at the base as the safest, then bonds, then equities, with derivatives and highly geared products at the top as the riskiest, reflecting their higher potential return and loss.

A common statistical measure of an investment's risk is:

• a.The bond's coupon rate
• b.The price-to-earnings ratio
• c.The standard deviation (volatility) of its returns✓
• d.The dividend yield paid on the share, since a higher dividend yield always signals a much lower level of risk

Standard deviation measures how widely returns vary around their average: the greater the dispersion, the more volatile and, in this sense, risky the investment. It is a core input to portfolio-risk analysis.

The 'beta' of a share measures:

• a.The prevailing rate of inflation across the whole economy in which the company happens to conduct its business
• b.The coupon on the company's bonds
• c.How sensitive the share's return is to movements in the overall market✓
• d.The dividend the company pays

Beta gauges systematic risk: a beta of 1 moves in line with the market, above 1 amplifies market moves, and below 1 is less sensitive. It helps investors understand how a stock may behave relative to the market.

Regarding liquidity, blue-chip shares compared with small-cap shares are:

• a.Identical in liquidity to small-caps
• b.Much less liquid and considerably harder to trade in size than the shares of a typical small-cap company
• c.Impossible to trade on the exchange
• d.Generally more liquid and easier to trade in size✓

Blue chips attract heavy trading volume and many buyers and sellers, so large orders can be executed with limited price impact. Small-caps trade thinly, making them harder and costlier to buy or sell in quantity.

The difference between a price index and a total-return index is that:

• a.A price index includes the dividends paid by its constituents, assuming those dividends are all reinvested
• b.They are calculated identically
• c.A total-return index ignores dividends
• d.A total-return index assumes dividends are reinvested, whereas a price index reflects price changes only✓

A price index tracks only capital movements in its constituents. A total-return index also adds the dividends, assuming they are reinvested, so it captures the full return an investor would earn.

Reinvesting the income from an investment rather than spending it:

• a.Reduces the investor's total return over time, because the income is no longer available to be spent freely
• b.Has no effect on compounding
• c.Increases growth only if the income is spent
• d.Lets returns compound, boosting the long-run value of the investment✓

When dividends or coupons are reinvested, they themselves start to earn returns, so the portfolio compounds. Over long horizons this reinvestment of income accounts for a large part of total accumulated wealth.

An investor's time horizon affects risk capacity because:

• a.The shortest horizons suit the most volatile assets
• b.A longer investment horizon generally allows an investor to ride out short-term volatility and take on more risk✓
• c.The time horizon is irrelevant to how much risk is suitable
• d.A longer investment horizon always requires the very lowest-risk assets, regardless of the investor's goals

With more time before the money is needed, an investor can wait out market downturns and let volatile assets recover, so a longer horizon usually supports a higher-risk, higher-return allocation.

Dollar-cost averaging is the practice of:

• a.Investing a fixed amount at regular intervals, buying more units when prices are low and fewer when high, smoothing the average cost✓
• b.Trying to time the market perfectly
• c.Selling investments whenever prices fall
• d.Investing a single large lump sum right at the top of the market just before prices begin to fall back again

By committing the same sum each period regardless of price, an investor automatically buys more when markets are cheap and less when dear, averaging the entry cost and reducing the risk of a badly timed lump sum.

Asset allocation refers to:

• a.Holding only cash at all times
• b.Spreading investments across different asset classes such as equities, bonds and cash to balance risk and return✓
• c.Concentrating the whole of the portfolio into a single share in the hope of maximising the potential return
• d.Borrowing heavily to invest

Asset allocation decides how a portfolio is divided among the major asset classes according to the investor's objectives and risk tolerance. It is a primary driver of both a portfolio's risk and its long-term return.

An investor buys a share at HK$50 and sells it at HK$56, receiving no dividend. The return is:

• a.6%
• b.10%
• c.12%✓
• d.56%

Return = capital gain / cost = (HK$56 - HK$50) / HK$50 = HK$6 / HK$50 = 12%. With no dividend, the whole return is the capital gain.

Expressing a return on an 'annualised' basis means:

• a.It is always a larger figure than the actual total return, because the calculation compounds the return up
• b.It ignores the length of the holding period
• c.It is identical to the dividend yield
• d.Stating the return as the equivalent rate per year, so investments held over different periods can be compared✓

Annualising converts a return earned over any period into a comparable yearly figure. This lets an investor compare, say, a three-month and a two-year investment on the same standardised basis.

The difference between a gross return and a net return is that:

• a.They are always exactly equal
• b.The net return is what remains after deducting fees, costs and any taxes from the gross return✓
• c.The gross return is the figure that is left over only after all fees, costs and taxes have been deducted
• d.The net return is measured before any costs

Gross return is the headline performance before expenses. Net return subtracts management fees, transaction costs and taxes, giving the actual return the investor keeps, which is what matters in practice.