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Question

Difficulty: MediumNon-Systematic and Credit Risks

An investor holds a portfolio heavily concentrated in debt securities issued by a regional logistics company. Concerned about potential financial distress and default by this specific issuer, the investor rebalances the portfolio by redistributing funds across bonds issued by companies in several unrelated industries. Which of the following best categorizes the primary risk the investor reduced through this portfolio rebalancing?

  1. Non-systematic risk, because issuer-specific credit and business risks can be mitigated through diversification.Answer
  2. B
    Interest rate risk, because spreading investments across different bond issuers protects the bond values when market rates rise.
  3. C
    Systematic risk, because diversifying across different corporate sectors eliminates broad market risk.
  4. D
    Inflation risk, because holding bonds from companies in different industries maintains purchasing power during periods of rising prices.

Answer

Non-systematic risk is reduced, because issuer-specific credit and business risks can be mitigated through diversification.
The correct option correctly identifies non-systematic risk. Risks associated with a specific company's operational or financial failure (business and credit risk) are non-systematic and can be effectively mitigated or eliminated by diversifying across multiple issuers and industry sectors.

Step-by-Step Solution

1
Identify the nature of the risk described in the scenario.
The risk of financial distress or default by a specific regional logistics company is an issuer-specific (non-systematic) business and credit risk.
Risk tied to an individual company's financial stability is non-systematic.
2
Evaluate the effect of portfolio diversification on non-systematic vs. systematic risk.
Diversifying holdings across multiple unrelated companies and industries reduces exposure to any single company defaulting.
Non-systematic risks can be substantially reduced or eliminated through proper diversification, whereas systematic risks (such as interest rate or market risk) affect the entire market and cannot be diversified away.

Key Concept

Non-Systematic Risk and Diversification
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Topics

Non-Systematic and Credit Risks

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