Examkin

Question

Difficulty: Very hardNon-Systematic and Credit Risks

An analyst evaluates two fixed-income holdings in a portfolio during a period of changing market conditions:

1. A 10-year senior corporate bond issued by a manufacturing firm whose credit rating was downgraded from A to BBB following a sharp drop in operating revenue.
2. A 10-year U.S. Treasury note whose market value declined after the Federal Reserve raised benchmark interest rates by 50 basis points.

Which of the following correctly classifies the primary risk each security demonstrated?

  1. The corporate bond demonstrated non-systematic credit risk, whereas the U.S. Treasury note demonstrated systematic interest rate risk.Answer
  2. B
    The U.S. Treasury note demonstrated credit risk due to its loss of principal market value, whereas the corporate bond demonstrated systematic market risk.
  3. C
    Both securities demonstrated non-systematic business risk because their valuation changes were triggered by economic factors.
  4. D
    The corporate bond demonstrated systematic credit risk, while the U.S. Treasury note demonstrated non-systematic purchasing power risk.

Answer

The corporate bond demonstrated non-systematic credit risk, whereas the U.S. Treasury note demonstrated systematic interest rate risk.
Credit risk refers to the risk that an issuer may fail to meet principal or interest obligations, or suffer a downgrade in credit rating due to issuer-specific financial troubles. Because this risk is unique to the underlying company, it is non-systematic (unsystematic) and can be minimized through portfolio diversification. Conversely, U.S. Treasury securities have virtually no credit risk; price declines in Treasuries following Federal Reserve rate hikes reflect systematic interest rate risk, which impacts fixed-income securities across the entire financial system.

Step-by-Step Solution

1
Analyze the cause of value change for the corporate bond.
The credit rating downgrade from A to BBB stems from company-specific operational decline (reduced revenue and cash flow).
Issuer-specific financial health and potential default risk represent credit risk, which is a non-systematic (diversifiable) risk.
2
Analyze the cause of value change for the U.S. Treasury note.
The market price decline resulted directly from a central bank benchmark interest rate increase.
Broad market price fluctuations driven by changes in prevailing interest rates affect all fixed-income instruments and represent systematic (non-diversifiable) interest rate risk.
3
Synthesize the risk classifications for both assets.
The corporate bond displays non-systematic credit risk, while the Treasury note displays systematic interest rate risk.
This correctly distinguishes between issuer-specific financial risk and market-wide rate sensitivity.

Key Concept

Distinguishing Non-Systematic Credit Risk from Systematic Interest Rate Risk
Rate this question

Topics

Non-Systematic and Credit Risks

More questions from this topic