Examkin

Question

Difficulty: HardNon-Systematic and Credit Risks

An investor holds a 15-year corporate bond issued by a biotechnology firm. Following an unsuccessful clinical trial for its flagship drug, the issuing firm experiences significant operational revenue losses, prompting a credit rating agency to downgrade the bond from investment grade to speculative grade. Simultaneously, the Federal Reserve lowers benchmark interest rates, causing prevailing market yields across the economy to drop. Which of the following statements correctly evaluates the financial risks and price pressures acting on this bond?

  1. The clinical trial failure represents a business (non-systematic) risk that increases credit risk and exerts downward pressure on the bond price, whereas the benchmark rate drop is an interest rate (systematic) risk that exerts upward pressure on the bond price.Answer
  2. B
    The rating downgrade and clinical trial failure represent systematic market risks, meaning the resulting risk can be eliminated by expanding the investor's portfolio into other biotechnology debt securities.
  3. C
    The clinical trial failure increases interest rate risk for the issuer, while the Federal Reserve's rate cut directly reduces the bond's credit default risk.
  4. D
    The decrease in prevailing market interest rates causes the bond's price to decline, while the credit rating downgrade increases its secondary market price.

Answer

The clinical trial failure represents business (non-systematic) risk that heightens credit risk and exerts downward pressure on the bond's price, whereas the benchmark interest rate drop reflects systematic market conditions that exert upward price pressure.
The failure of a clinical trial is an event specific to the issuing company, which exemplifies business risk—a form of non-systematic risk. This deteriorates the issuer's creditworthiness and increases default risk, leading to a credit downgrade that depresses the bond's price. Conversely, changes in market interest rates dictated by macroeconomic factors represent systematic interest rate risk. Because bond prices move inversely to prevailing interest rates, falling market rates create upward pressure on the bond's price.

Step-by-Step Solution

1
Analyze the impact of the clinical trial failure on the bond issuer.
The failure is an issuer-specific operational event, defining it as business (non-systematic) risk.
Business risk directly impairs the firm's cash flow, elevating credit (default) risk and causing rating downgrades that push bond prices down.
2
Analyze the impact of the Federal Reserve's interest rate cut.
Economy-wide rate shifts represent systematic interest rate risk.
Because existing fixed-income prices move inversely to interest rates, falling market interest rates place upward pressure on bond market values.
3
Synthesize the combined effect of non-systematic and systematic risks.
The security experiences two opposing forces: downward pressure from increased credit risk and upward pressure from falling market interest rates.
Non-systematic credit factors and systematic macroeconomic interest rate factors operate independently on fixed-income instruments.

Key Concept

Non-Systematic (Business/Credit) Risk vs. Systematic (Interest Rate) Risk
Rate this question

Topics

Non-Systematic and Credit Risks

More questions from this topic