CFA Practice Question

There are 266 practice questions for this study session.

CFA Practice Question

Longbay Corporation has obtained a $1 million loan to acquire construction-related equipment. Unbeknownst to the lender, Longbay decides to spend the money on a different type of equipment, which has a market risk that is the same as the original equipment but the potential returns of which have more volatility or dispersion. Because of this asset substitution, the creditor experiences ______.

A. greater market risk
B. less market risk
C. greater default risk
Correct Answer: C

A greater variance (dispersion) of potential returns increases default risk. This is the risk that Longbay will not repay the loan.

User Contributed Comments 5

User Comment
sarath Market risk is the interest rate risk...
2014 question says market risk is same, obvious answer is default risk
schweitzdm How does a piece of equipment have volatility in returns? Is the question implying that the company they are buying the equipment from has more returns as a business entity?

I am confused because I do not see how these would affect Longbay. If Longbay buys equipment and is going to use them to build or sell, what is the difference if they indeed receive the equipment they're buying? What does the supplier of equipment have to do with it?

Perhaps I am over-thinking this question but I believe further elaboration would be beneficial.
schweitzdm I just re-read the question and I understand the answer to my comment above. The equipment will generate a different amount of returns for Longbay and that is the heart of the question.
khalifa92 and volatility is the core of the heart.
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