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Difficulty: EasyNon-Systematic and Credit Risks

An investor purchases corporate bonds issued by a commercial airline company. The investor is concerned that unexpected fuel cost increases or operating losses could impair the airline's financial capability to make scheduled interest and principal payments. Which of the following risks does this concern represent?

  1. Credit risk, which is specific to the issuer's financial strength and ability to meet its debt obligations.Answer
  2. B
    Interest rate risk, which causes existing bond prices to drop when prevailing interest rates rise across the economy.
  3. C
    Market risk, which represents general market volatility that impacts all corporate securities simultaneously.
  4. D
    Inflation risk, which reduces the future purchasing power of fixed interest payments due to rising consumer prices.

Answer

Credit risk, which is specific to the issuer's financial strength and ability to meet its debt obligations.
Credit risk (also called default risk) refers to the probability that a specific bond issuer will experience financial distress and fail to make timely interest or principal payments.

Step-by-Step Solution

1
Identify the source of risk described in the scenario.
The investor is concerned about company-specific operational costs (fuel) impacting debt service capability.
Factors affecting a single issuer's financial stability fall under non-systematic risk.
2
Select the correct category of non-systematic risk.
The possibility of an issuer defaulting on interest or principal payments is defined as credit risk.
Credit risk measures issuer solvency, distinguishing it from broader market-wide systematic risks.

Key Concept

Credit risk is a non-systematic risk reflecting an issuer's potential failure to make timely interest or principal payments.
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Topics

Non-Systematic and Credit Risks

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