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Difficulty: HardNon-Systematic and Credit Risks

A fixed-income investor holds a portfolio of various fixed-income securities. Following an unexpected regulatory ruling that revokes a key operating license, a mid-sized telecommunications firm experiences a severe credit rating downgrade, causing its debt securities to plummet in price while broad market bond yields and benchmark U.S. Treasury prices remain completely unaffected. Which of the following best characterizes the principal risk that has materialized for this specific bondholder?

  1. Business and credit risk, which is a non-systematic risk specific to the issuing firm that can be minimized through asset diversification.Answer
  2. B
    Interest rate risk, which is a systematic risk affecting all fixed-income obligations regardless of issuer creditworthiness.
  3. C
    Purchasing power risk, which is a systematic risk that cannot be reduced even when diversifying across multiple corporate issuers.
  4. D
    Market risk, which is a systematic risk triggered by macroeconomic central bank policy shifts across the communications sector.

Answer

The decline in bond price represents business and credit risk, which is a non-systematic (unsystematic) risk specific to the issuing firm and can be effectively mitigated through portfolio diversification.
The correct option correctly identifies the incident as business and credit risk. Because the price decline was triggered solely by a company-specific regulatory license revocation—while broad benchmark bond prices remained stable—the risk is non-systematic (unsystematic) and unique to that issuer. Investors can mitigate this risk by diversifying across multiple issuers.

Step-by-Step Solution

1
Analyze the cause of the security price drop.
The price drop was caused by an isolated regulatory action revoking a specific company's operating license, leading to an issuer credit downgrade.
Events tied strictly to an individual issuer's operational viability or credit rating reflect business and credit risk.
2
Differentiate between systematic and non-systematic risk types based on market response.
Because broad market bond yields and benchmark U.S. Treasury prices remained unaffected, the event is non-systematic (unsystematic) rather than systematic (market-wide).
Systematic risks (such as interest rate or purchasing power risk) impact the market broadly, whereas non-systematic risks impact specific companies or industry segments.
3
Identify the primary risk management strategy for non-systematic risk.
Non-systematic risk can be substantially reduced or eliminated by diversifying investments across different issuers and sectors.
Holding a variety of non-correlated assets prevents a single firm's default or operational failure from causing catastrophic portfolio losses.

Key Concept

Non-Systematic (Unsystematic) Risk vs. Systematic Risk and Credit Risk Mitigation
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Topics

Non-Systematic and Credit Risks

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