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Difficulty: MediumSystematic and Market Risks

An investor maintains a portfolio that is broadly diversified across multiple domestic industries and asset classes. During a sudden macroeconomic downturn, the overall equity market experiences a sharp decline, causing the investor's portfolio value to fall despite its wide diversification. Which of the following risk management strategies would provide an effective hedge against this remaining systematic risk?

  1. Purchasing broad-market index put optionsAnswer
  2. B
    Increasing the number of individual domestic equity holdings across more business sectors
  3. C
    Reallocating the entire portfolio into long-term fixed-income securities to eliminate overall market price sensitivity
  4. D
    Reallocating assets into speculative corporate bonds because an inverted yield curve signals robust future economic expansion

Answer

Purchasing broad-market index put options
Purchasing broad-market index put options allows an investor to establish a floor on portfolio losses caused by market-wide downturns. Because systematic risk impacts the broader market as a whole, index options act as an effective hedge against market risk.

Step-by-Step Solution

1
Identify the nature of the risk affecting the portfolio.
The broad decline driven by macroeconomic factors represents systematic (market) risk, which affects all market participants and cannot be eliminated through diversification.
Systematic risk stems from macroeconomic events that impact the aggregate market.
2
Evaluate hedging mechanisms suitable for systematic market risk.
Purchasing index put options gives the holder the right to sell at a specified strike price, offsetting portfolio losses when the broader market declines.
Derivatives linked to broad market indexes directly hedge market-wide movements.

Key Concept

Systematic risk (market risk) affects the overall market and cannot be eliminated by diversification, but it can be hedged using index options.
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Topics

Systematic and Market Risks

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