Concentration Risk

An adviser places a one-year collar on a large single-stock holding for a client. In explaining what the collar does and does not accomplish, the essential point is that it

1. A.converts the concentrated holding into a diversified position for the duration.Wrong. It changes the payoff on the shares while leaving the client holding one company.
2. B.removes the need to monitor the position, since both ends of the outcome are fixed.Wrong. The expiry, the tax position and the eventual disposition all still require attention.
3. C.permanently caps the downside, because the collar can always be renewed on these terms.Wrong. Renewal happens at whatever terms the market offers then, which cannot be known now.
4. D.limits the price exposure for a year but leaves the client concentrated when it expires.Correct. It separates the temporary payoff change from the underlying concentration that survives it.

Why: A collar reshapes the payoff on the shares for a defined period, putting a floor beneath them and a ceiling above them, and it does that without the client selling anything. What it does not do is change what the client owns, so at expiration the position is still a single company held in the same size, with the same business risk and the same concentration. The hedge buys time and limits damage within its term rather than solving the underlying problem. Renewal is possible but only at whatever terms prevail then, which cannot be known when the first collar is written.

A client holds a large share of her investable assets in the stock of the employer that also pays her salary. Her adviser explains that this position is worse than an equivalent concentration in an unrelated company because

1. A.shares of an employer are typically more volatile than shares of comparable companies.Wrong. No such general rule exists, and volatility is not where the added danger comes from.
2. B.holding employer shares above a stated proportion of a portfolio is prohibited.Wrong. No such limit is imposed on an ordinary taxable portfolio; the issue is prudence rather than permission.
3. C.her employment income and the share price respond to the same underlying business risk.Correct. The correlation means one adverse event damages her income and her portfolio at the same moment.
4. D.she would be unable to sell the shares for as long as she remains employed there.Wrong. Restrictions bind some employees at some times, and nothing in the facts establishes one here.

Why: Concentration risk is bad enough on its own, but here it is correlated with the other side of the client balance sheet. A downturn in the business threatens her salary, her job security and the value of the holding simultaneously, so the very event that creates a need to draw on the portfolio is the event that shrinks it. Diversification is meant to ensure that one adverse development does not damage two things at once, and employer stock defeats that purpose by design. An equivalent position in an unrelated company would carry the same single-name risk without the correlation to her income.

A client holds a very large position in one company with a very low cost basis. Her adviser is weighing a collar against selling part of the position outright. The consideration that most favours the partial sale is that

1. A.a collar defers the tax, and deferral is always to be preferred to paying now.Wrong. Deferral has value but also a price, and here the price is continued concentration.
2. B.a collar cannot be used on a position of that size in any event.Wrong. No size limitation applies; the objection is to what the collar does, not to whether it can be done.
3. C.a sale permanently reduces the exposure, while a collar postpones the decision and expires.Correct. Permanence is exactly the thing the hedge cannot supply, however well it works within its term.
4. D.a sale avoids the tax, whereas the collar accelerates it.Wrong. It inverts the tax picture entirely, since the sale is what triggers the gain.

Why: Two sound principles pull in opposite directions here: deferring a tax preserves capital that would otherwise be paid away, while diversifying removes a risk that no hedge permanently addresses. The collar defers the tax but expires, leaving the client holding the same concentrated position and facing the same decision under whatever market and tax conditions then apply. A partial sale costs tax now and permanently removes that portion of the exposure, which is the one thing the hedge cannot do. Which consideration should win depends on the size of the embedded gain and how much of her total wealth the position represents.