A financial analyst is reviewing a fixed-income portfolio containing corporate debt issued by a manufacturing firm that recently suffered severe operational supply disruptions and a subsequent debt rating downgrade from BBB- to BB+. Which of the following statements regarding the non-systematic and credit risks affecting these debt holdings are correct?
- The supply disruption represents business risk, which is a form of non-systematic risk that can be mitigated through asset diversification.Answer
- The credit rating downgrade reflects an increase in default risk, raising the credit risk premium demanded by investors in the secondary market.Answer
- CThe credit rating downgrade transforms the issuer's firm-specific risk into systematic market risk for all corporate bondholders.
- DReallocating capital across a wider selection of corporate issuers will eliminate the portfolio's overall exposure to interest rate risk.
Answer
The statements identifying the operational disruption as a diversifiable business risk and connecting the debt rating downgrade to heightened default risk are correct.
The correct options accurately characterize business risk and credit risk as non-systematic factors. Business risk arises from operational challenges specific to a company, such as supply disruptions, and can be reduced by diversifying investments across different firms and sectors. Credit risk measures an issuer's likelihood of defaulting on its debt obligations, which increases when a rating agency downgrades an issue to speculative grade.
Step-by-Step Solution
Key Concept
Distinguishing Non-Systematic (Business and Credit) Risk from Systematic Market Risk
Estimated Time:2m 0s