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Difficulty: HardSystematic and Market Risks

A financial advisor is evaluating a client's investment portfolio, which contains 120 individual domestic stocks across all major market sectors, long-term corporate bonds, and international equity funds. Although the portfolio is broadly diversified across multiple issuers and industries, the advisor notes that it remains exposed to systematic risks. Which of the following statements regarding the systematic risk factors in this portfolio are correct?

  1. Purchasing power risk cannot be eliminated simply by increasing the number of fixed-income security issuers within the portfolio.Answer
  2. An unexpected rise in prevailing market interest rates will drive down the market value of the portfolio's long-term corporate bonds.Answer
  3. C
    Expanding diversification across additional corporate sectors will completely eliminate the market risk of the domestic stock holdings.
  4. D
    An inverted yield curve indicates economic expansion, which automatically neutralizes foreign currency risk for the international fund holdings.

Answer

The correct statements are that purchasing power risk cannot be eliminated simply by increasing the number of bond issuers, and that an unexpected rise in prevailing market interest rates will drive down the market value of long-term corporate bonds.
Systematic risks (including market risk, interest rate risk, and purchasing power risk) stem from broad macroeconomic factors and affect entire market asset classes. Consequently, holding multiple bond issuers does not eliminate the systematic erosion of fixed payments caused by inflation, and rising prevailing interest rates systematically depress existing fixed-income valuations due to their inverse relationship.

Step-by-Step Solution

1
Analyze the nature of systematic (market-wide) risks versus unsystematic (specific) risks.
Systematic risks—such as market risk, interest rate risk, inflation risk, and currency risk—impact the market as a whole and cannot be eliminated through diversification.
Understanding non-diversifiability is the core distinction of systematic risk in portfolio management.
2
Evaluate the statement regarding purchasing power risk and bond issuer diversification.
The statement is correct because inflation affects the real purchasing power of fixed payments across all bond issuers equally.
Diversification reduces unsystematic credit/default risk, not systematic inflation risk.
3
Evaluate the statement regarding interest rate changes and bond price movements.
The statement is correct because interest rate risk causes bond prices to fall when interest rates rise.
Bonds and interest rates have a fundamental inverse relationship.
4
Evaluate the statements regarding sector diversification removing market risk and inverted yield curves neutralizing currency risk.
Both statements are incorrect: market risk cannot be eliminated by sector diversification, and an inverted yield curve signals recession (not expansion) while having no mechanism to neutralize currency risk.
Systematic risks remain regardless of equity sector coverage, and macroeconomic yield curves do not remove currency volatility.

Key Concept

Systematic risks affect the entire financial system or market segment and cannot be eliminated through asset diversification.
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Topics

Systematic and Market Risks

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