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Difficulty: HardSystematic and Market Risks

A financial advisor is reviewing an investor's portfolio, which is currently split evenly between a diversified broad-market basket of U.S. mega-cap stocks and long-term fixed-rate corporate bonds. The investor anticipates a challenging economic period marked by aggressive Federal Reserve interest rate hikes and persistent inflation. Which of the following statements correctly evaluate the systematic risks affecting this portfolio and the strategies available to mitigate them?

  1. Purchasing put options on a broad-based stock index can hedge the equity portion of the portfolio against market risk.Answer
  2. B
    Increasing the number of individual domestic stock holdings will fully eliminate the portfolio's exposure to interest rate risk.
  3. The portfolio's long-term fixed-rate corporate bonds are subject to purchasing power risk because fixed interest payments lose real value during inflationary periods.Answer
  4. D
    Rising benchmark interest rates will cause the secondary market prices of the existing fixed-rate corporate bonds to increase.

Answer

The correct statements are that purchasing put options on a broad-based stock index can hedge market risk, and long-term fixed-rate corporate bonds are exposed to purchasing power risk during inflationary periods.
Purchasing index put options provides effective downside protection against systematic market risk for an equity portfolio. Additionally, fixed-rate bonds inherent to fixed-income portfolios carry purchasing power risk because inflation erodes the real value of fixed interest payments over time.

Step-by-Step Solution

1
Analyze the impact of systematic risk and diversification on equity exposure.
Systematic risks, such as market risk and interest rate risk, affect the entire market and cannot be diversified away simply by adding more domestic stocks. However, index options (such as buying index puts) can be utilized to hedge systematic market downturns.
Diversification reduces non-systematic (business-specific) risk, not systematic risk.
2
Evaluate the risk characteristics of long-term fixed-rate bonds in an inflationary and rising interest rate environment.
Fixed-rate bonds suffer from purchasing power risk because fixed coupon income loses purchasing power when prices rise. Furthermore, as market interest rates increase, existing bond prices decrease due to their inverse relationship.
Investors demand higher yields on newly issued bonds, driving down secondary market values for existing lower-yielding fixed-rate bonds.

Key Concept

Systematic Risk Subtypes and Limitations of Diversification
Estimated Time:2m 0s
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Topics

Systematic and Market Risks

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