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Difficulty: MediumNon-Systematic and Credit Risks

A credit rating agency downgrades a corporate bond issued by a commercial satellite communications firm after the company loses a major government service contract, leading to a drop in the bond's market price while overall market interest rates remain stable. Which type of risk has affected this investment, and how can a fixed-income investor best protect a portfolio against this specific risk?

  1. Credit risk, which can be mitigated by diversifying holdings across different corporate issuers and sectors.Answer
  2. B
    Interest rate risk, which can be mitigated by diversifying holdings across different corporate issuers and sectors.
  3. C
    Systematic market risk, which can be mitigated by diversifying holdings across different corporate issuers and sectors.
  4. D
    Call risk, which can be eliminated by purchasing bonds with longer maturities.

Answer

Credit risk, which can be mitigated by diversifying holdings across different corporate issuers and sectors.
The correct answer correctly identifies credit risk as the vulnerability to an issuer's downgrade or financial default. Because credit risk is non-systematic (unique to a specific company or issuer), it can be effectively mitigated through portfolio diversification across various companies and sectors.

Step-by-Step Solution

1
Analyze the cause of the bond's price decline described in the scenario.
The price decline was triggered by a corporate event (loss of a major contract leading to a rating downgrade), unique to the satellite communications firm, while market interest rates remained unchanged.
Identifying whether the risk stem is firm-specific or market-wide distinguishes non-systematic risk from systematic risk.
2
Classify the specific risk type.
Financial difficulty leading to a downgrade or default risk is defined as credit risk, which is a non-systematic (unsystematic) risk.
Credit risk measures the financial strength of the individual issuer.
3
Determine the appropriate risk management technique.
Non-systematic risks can be significantly reduced or eliminated through asset diversification across multiple issuers, industries, and asset classes.
Diversification prevents losses in a single firm from severely impairing the overall portfolio.

Key Concept

Credit risk is a non-systematic risk associated with an issuer's financial stability and can be managed through portfolio diversification.
Estimated Time:1m 0s
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Topics

Non-Systematic and Credit Risks

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