An investor holds a fixed-income portfolio heavily concentrated in speculative-grade corporate debentures issued by a single technology corporation. The investor expresses concern that deteriorating cash flows at the firm may result in a failure to pay scheduled interest coupons. Which type of risk is the investor primarily exposed to, and how can this specific risk be most effectively reduced?
- AInterest rate risk, which can be mitigated by holding the corporate debentures to maturity.
- Credit risk, which can be significantly reduced by diversifying the portfolio across issuers in different sectors.Answer
- CMarket risk, which can be eliminated by diversifying holdings across different corporate bond issuers.
- DCredit risk, which is a systematic risk factor that cannot be reduced through asset allocation or diversification.
Answer
Credit risk (or default risk), which is a non-systematic risk that can be mitigated by diversifying holdings across multiple issuers and industry sectors.
Credit risk (also known as default risk) is the risk that an issuer will fail to make timely payments of interest or principal. Because credit risk is non-systematic (specific to individual issuers), investors can effectively manage and reduce this risk by diversifying their investments across multiple issuers and industry sectors.
Step-by-Step Solution
Key Concept
Credit Risk Identification and Non-Systematic Risk Diversification
Estimated Time:1m 0s