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Difficulty: HardNon-Systematic and Credit Risks

An investor holds a portfolio comprising U.S. Treasury bonds, speculative-grade corporate debt, and common equity in a single regional healthcare firm. When evaluating the portfolio's exposure to non-systematic and credit risks, which of the following statements are correct?

  1. The speculative-grade corporate debt introduces credit risk to the portfolio, which can be effectively mitigated through fixed-income issuer diversification.Answer
  2. The equity position in the single regional healthcare firm exposes the investor to business risk that can be reduced by investing across multiple companies and industries.Answer
  3. C
    The U.S. Treasury bonds carry substantial credit risk during rate-hiking cycles because rising prevailing interest rates lower their secondary market values.
  4. D
    Diversifying the corporate debt holdings across various corporate issuers will eliminate the fixed-income portion's overall interest rate risk.

Answer

The correct statements are that speculative-grade corporate debt introduces credit risk which can be mitigated through issuer diversification, and that the single equity holding carries business risk which can be reduced by diversifying across companies and sectors.
The correct options accurately distinguish non-systematic risks (credit risk of corporate debt and business risk of individual equity) from systematic risks. Non-systematic risks are unique to individual issuers or industries and can be mitigated through asset diversification.

Step-by-Step Solution

1
Differentiate between systematic (market-wide) and non-systematic (company- or issuer-specific) risks.
Identified that business risk and credit risk are non-systematic, while interest rate risk is systematic.
Non-systematic risks affect specific entities and can be diversified away, whereas systematic risks affect the entire market.
2
Evaluate the risk characteristics of speculative-grade corporate debt and single-stock equity holdings.
Determined that speculative-grade debt incurs credit risk and single-stock equity incurs business risk, both of which decrease with proper asset diversification.
Diversification spreads exposure so that adverse events at one issuer do not severely impact the entire portfolio.
3
Analyze the claims regarding U.S. Treasury bonds and interest rate risk elimination.
Recognized that price drops from rising rates reflect interest rate risk (systematic risk), not credit risk, and that diversification cannot remove systematic interest rate risk.
U.S. Treasuries are backed by the full faith and credit of the U.S. government (no credit risk), and interest rate risk affects all fixed-income assets universally.

Key Concept

Mitigation of Non-Systematic and Credit Risks via Diversification
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Topics

Non-Systematic and Credit Risks

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