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Difficulty: MediumSystematic and Market Risks

A retail investor places her long-term savings into a portfolio consisting exclusively of 3030-year U.S. Treasury zero-coupon bonds, believing that avoiding corporate default risk ensures total safety. During an extended period of rising inflation and increasing market interest rates, she notices a significant decline in her portfolio's purchasing power and secondary market value. Which of the following statements correctly evaluates the risk profile of this investor's holdings?

  1. The portfolio remains exposed to systematic risks, specifically purchasing power risk and interest rate risk, which cannot be eliminated through fixed-income diversification.Answer
  2. B
    The portfolio's market value loss is primarily caused by credit risk, which could have been avoided by diversifying into high-yield corporate bonds.
  3. C
    The investor can completely eliminate market and inflation risks by expanding her holdings across 100100 different U.S. Treasury bond maturities.
  4. D
    As prevailing interest rates rise, the secondary market price of zero-coupon Treasury bonds increases, offsetting the negative effects of inflation.

Answer

The portfolio remains exposed to systematic risks, specifically purchasing power risk and interest rate risk, which cannot be eliminated through fixed-income diversification.
The correct response reflects that while U.S. Treasury securities eliminate issuer default risk (a non-systematic risk), they remain fully exposed to systematic risks such as interest rate risk and purchasing power (inflation) risk. Systematic risks impact the overall market and fixed-income sector, so diversifying among government bonds does not remove these exposures.

Step-by-Step Solution

1
Identify the nature of the securities in the portfolio
U.S. Treasury zero-coupon bonds carry virtually zero credit (default) risk because they are backed by the U.S. government.
Understanding non-systematic credit risk helps isolate why default risk is not the cause of the loss.
2
Analyze the impact of rising inflation and interest rates
Rising inflation erodes fixed future cash flows (purchasing power risk), while rising interest rates depress the present market value of long-term bonds (interest rate risk).
Both inflation and interest rate fluctuations represent systematic risks affecting the entire market.
3
Evaluate the limits of diversification regarding systematic risk
Systematic risks affect the broader financial system and overall economy; asset diversification cannot remove systematic risk.
Diversification reduces non-systematic risk (issuer-specific risk), but systematic risk remains present across debt instruments.

Key Concept

Systematic risks (such as interest rate risk and purchasing power risk) affect the market as a whole and cannot be eliminated through asset diversification.
Estimated Time:1m 30s
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Topics

Systematic and Market Risks

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