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Question

Difficulty: MediumNon-Systematic and Credit Risks

An investor purchases short-term commercial paper issued by a manufacturing firm. Prior to the maturity date, the issuing corporation suffers unexpected operational losses and fails to pay the scheduled principal at maturity. Which of the following risks has primarily materialized for the investor?

  1. Credit risk, which arises from the financial inability of a specific issuing corporation to fulfill its interest or principal debt obligations.Answer
  2. B
    Interest rate risk, which measures price fluctuations caused by changes in prevailing market interest rates.
  3. C
    Market risk, which reflects overall price declines across all fixed-income securities due to broader economic forces.
  4. D
    Purchasing power risk, which stems from inflationary pressures eroding the future buying power of fixed returns.

Answer

The risk that primarily materialized is credit risk, because the loss stems directly from the issuing corporation defaulting on its obligation to repay principal.
The correct option identifies credit risk, which directly refers to the risk that a debt issuer will fail to make required interest or principal payments due to financial difficulties.

Step-by-Step Solution

1
Analyze the cause of loss described in the scenario.
The loss occurred because the specific issuer suffered financial distress and defaulted on debt obligations upon maturity.
Identifying the root cause of financial loss distinguishes between systematic market forces and issuer-specific factors.
2
Categorize the risk as systematic or non-systematic.
Failure to pay interest or principal by a single corporation is a non-systematic, issuer-specific risk.
Non-systematic risks stem from events unique to an individual company or entity.
3
Select the specific non-systematic risk definition matching issuer failure.
Credit (default) risk specifically covers non-payment of principal or interest by an issuer.
Credit risk applies directly to fixed-income debt securities when the obligor defaults.

Key Concept

Credit Risk (Default Risk) as a Non-Systematic Risk
Estimated Time:1m 0s
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Topics

Non-Systematic and Credit Risks

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