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Difficulty: HardNon-Systematic and Credit Risks

Investors holding individual corporate and municipal securities encounter various forms of non-systematic risk that stem from issuer-specific operations, capital structures, or contract terms. Match each non-systematic risk type on the left with the specific financial scenario on the right that best illustrates it.

  • Credit (Default) RiskA municipal revenue bond issuer suffers severe revenue shortfalls and fails to make scheduled semi-annual coupon payments to bondholders.
  • Business RiskA biotechnology firm experiences a sharp decline in equity value after failing to receive regulatory approval for its lead pharmaceutical candidate.
  • Liquidity (Marketability) RiskAn investor holding high-yield corporate debt is forced to liquidate positions in a thinly traded market at a significant discount to fair market value.
  • Call RiskA corporate bond issuer redeems outstanding debt prior to maturity during a period of falling interest rates, forcing investors to reinvest funds at lower yields.

Answer

Credit Risk matches the municipal bond payment failure; Business Risk matches the pharmaceutical regulatory approval rejection; Liquidity Risk matches selling thinly traded debt at a major discount; Call Risk matches early debt retirement in a declining interest rate environment.
Each non-systematic risk is correctly matched to its specific issuer or contract mechanism: Credit Risk matches default on coupon payments; Business Risk matches operational setback from drug approval failure; Liquidity Risk matches price concessions required in thinly traded markets; Call Risk matches early debt retirement by issuers during falling rate environments.

Step-by-Step Solution

1
Identify the core characteristic of Credit (Default) Risk.
Credit risk involves the inability of a debt issuer to satisfy interest or principal obligations. The scenario describing a municipal revenue bond issuer failing to make scheduled coupon payments due to revenue shortfalls exemplifies credit risk.
Default directly reflects issuer financial distress leading to missed debt service.
2
Identify the core characteristic of Business Risk.
Business risk stems from company-specific operational metrics or commercial setbacks. The scenario describing a biotech company losing equity value due to an unsuccessful regulatory drug trial exemplifies business risk.
Operational failures directly impair the earning power and commercial viability of a specific firm.
3
Identify the core characteristic of Liquidity (Marketability) Risk.
Liquidity risk is the inability to sell a position quickly at or near fair market value. The scenario involving an investor in a thinly traded market forced to sell at a steep discount illustrates liquidity risk.
Illiquid secondary markets prevent swift execution without price concessions.
4
Identify the core characteristic of Call Risk.
Call risk occurs when debt securities are retired early by the issuer, typically when market interest rates fall, leaving investors exposed to lower reinvestment yields. The scenario describing early debt redemption during falling interest rates matches call risk.
Issuers exercise call provisions to refinance debt at lower cost, depriving investors of higher yield.

Key Concept

Non-systematic risks are specific to individual issuers, industries, or security structures and can be mitigated through diversification, unlike systematic market risks.
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Topics

Non-Systematic and Credit Risks

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