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Question

Difficulty: MediumSystematic and Market Risks

An investor maintains a portfolio allocated across large-cap equity mutual funds, long-term corporate bonds, and foreign securities. Which of the following statements correctly describe systematic risks impacting this portfolio?

  1. Purchasing power risk reduces the real value of fixed income payments received from bond investments during periods of high inflation.Answer
  2. Interest rate risk causes the market values of existing fixed-income holdings to decline when prevailing interest rates in the economy rise.Answer
  3. C
    Broadly diversifying across dozens of different domestic equity sectors completely eliminates the market risk of the stock holdings.
  4. D
    The default risk of a single corporate bond issuer within the portfolio is classified as a systematic risk because it cannot be diversified away.

Answer

Purchasing power risk erodes the real buying power of fixed-income payments during inflation, and interest rate risk depresses existing bond values when general interest rates rise.
The correct options accurately identify purchasing power risk and interest rate risk as systematic risks that affect overall market valuations and fixed-income returns regardless of diversification.

Step-by-Step Solution

1
Differentiate between systematic and non-systematic risks.
Systematic risks stem from broad macroeconomic factors and affect the overall market, whereas non-systematic risks are specific to individual issuers or assets.
Understanding this boundary determines which risks persist regardless of portfolio diversification.
2
Evaluate statements describing inflation and interest rate effects.
Both purchasing power risk and interest rate risk affect broad market segments and represent systematic risk factors.
Inflation diminishes real returns system-wide, and rising interest rates decrease bond prices across the debt market.
3
Analyze diversification limits and single-issuer risks.
Diversification cannot remove systematic market risk, and single-issuer default risk is non-systematic.
Unsystematic risks can be diversified away, but market-wide downturns affect broadly held equity portfolios.

Key Concept

Systematic risk affects the overall market or economy and cannot be eliminated through asset diversification.
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Topics

Systematic and Market Risks

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