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Question

Difficulty: HardSystematic and Market Risks

An investor maintains a portfolio comprising 500 U.S. large-cap equities and 100 U.S. investment-grade corporate bonds. Anticipating potential Federal Reserve interest rate increases to combat persistent inflation, the investor adds 50 international equities and 30 municipal bonds across various sectors, believing that spreading capital across more issuers and sectors will entirely eliminate the portfolio's exposure to interest rate risk and broad market downturns. Which of the following statements accurately evaluates the portfolio's risk profile following these additions?

  1. The addition of international equities and municipal bonds further reduces unsystematic risk, but systematic risks such as interest rate risk and market risk remain unaffected by portfolio diversification.Answer
  2. B
    The expansion across new asset classes and geographic sectors successfully eliminates systematic risk through complete multi-asset diversification.
  3. C
    The municipal bond additions will rise in secondary market value during Federal Reserve interest rate hikes because higher prevailing rates increase existing bond market prices.
  4. D
    Federal Reserve monetary tightening that leads to an inverted yield curve indicates immediate broad economic expansion that insulates equity positions from market risk.

Answer

The addition of international equities and municipal bonds further reduces unsystematic risk, but systematic risks such as interest rate risk and market risk remain unaffected by portfolio diversification.
Systematic risks, including market risk and interest rate risk, affect the entire financial system and cannot be eliminated by adding more securities or diversifying across industries. Diversification only reduces unsystematic (business/issuer-specific) risk.

Step-by-Step Solution

1
Distinguish between systematic risk and unsystematic risk.
Systematic risks (e.g., market risk, interest rate risk, inflation risk) stem from macroeconomic factors affecting the broader financial market. Unsystematic risks (e.g., credit risk, business risk) stem from specific issuers or sectors.
Understanding risk categorization is essential to determine which risks can be mitigated through asset allocation and security selection.
2
Evaluate the impact of adding securities across diverse sectors and asset classes.
Adding securities lowers single-issuer concentration and eliminates unsystematic risk, but leaves the portfolio exposed to systematic market downturns and interest rate movements.
No amount of security diversification can remove non-diversifiable systematic risk.
3
Assess the impact of Federal Reserve rate hikes on fixed-income securities.
When interest rates rise, existing bond prices drop across all fixed-income sectors due to the inverse relationship between yield and market price.
Interest rate risk is a primary subtype of systematic risk that affects fixed-income assets uniformly.

Key Concept

Systematic risk (market risk, interest rate risk) affects the market as a whole and cannot be eliminated through diversification, whereas unsystematic risk is issuer-specific and can be diversified away.
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Topics

Systematic and Market Risks

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