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Difficulty: MediumNon-Systematic and Credit Risks

An investor holds a concentrated portfolio consisting entirely of commercial paper issued by a regional electric utility company. The utility recently suffered significant physical infrastructure damage following a severe storm, leading credit rating agencies to downgrade the company's short-term debt rating from A-1 to A-3. Which of the following statements regarding the risks associated with this investment position are correct?

  1. The credit rating downgrade reflects an increase in non-systematic credit risk, as the issuer's capacity to fulfill short-term debt obligations has declined.Answer
  2. The investor can significantly reduce this specific debt risk by reallocating funds across commercial paper from issuers in varied industries and geographic regions.Answer
  3. C
    The primary cause of the portfolio's value decline is systematic interest rate risk driven by broader Federal Reserve monetary policy shifts.
  4. D
    Reallocating the portfolio into short-term commercial paper of another electric utility located in the same regional storm corridor will completely eliminate non-systematic risk.

Answer

The statement identifying the credit rating downgrade as an increase in non-systematic credit risk and the statement noting that reallocating funds across varied industries and regions reduces specific debt risk are both correct.
The scenario describes a debt credit downgrade resulting from issuer-specific operational disruptions, which is a classic example of non-systematic credit risk. Non-systematic risk is unique to an issuer and can be effectively diluted and controlled through proper portfolio diversification across varied asset classes and economic sectors.

Step-by-Step Solution

1
Identify the primary risk type described in the scenario.
The risk stems from events specific to a single issuer (storm damage and subsequent debt downgrade of the utility company), which defines non-systematic (credit/business) risk.
Non-systematic risk is specific to an individual company or security, unlike systematic risk which affects the whole market.
2
Evaluate risk mitigation techniques for non-systematic risk.
Diversifying the portfolio across multiple uncorrelated issuers, industries, and regions mitigates non-systematic risk.
Spreading capital across distinct economic sectors prevents single-issuer default events from severely impacting the broader portfolio.
3
Distinguish non-systematic credit risk from systematic market risk and ineffective diversification.
Statements attributing the downgrade to Federal Reserve interest rate changes or suggesting diversification within the same narrow sector are incorrect.
Interest rate risk affects all fixed-income securities systematically, while sector-concentrated holdings fail to provide real diversification benefits.

Key Concept

Non-systematic credit risk is specific to an individual debt issuer and can be mitigated through asset diversification across un-correlated sectors.
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Topics

Non-Systematic and Credit Risks

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