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Question

Difficulty: EasyNon-Systematic and Credit Risks

A registered representative is conducting a portfolio review with a client holding corporate bonds and single-stock equities. Which of the following statements regarding non-systematic risk and credit risk are correct?

  1. Credit risk refers to the likelihood that a corporate issuer will fail to make timely payment of interest or principal.Answer
  2. Non-systematic risk can be significantly reduced by building a diversified portfolio across varied issuers and business sectors.Answer
  3. C
    U.S. Treasury bonds carry substantial credit risk because their market prices decline when interest rates rise.
  4. D
    Economy-wide recessions and overall market interest rate shifts are examples of non-systematic risk that diversification eliminates.

Answer

The correct statements are that credit risk is the risk of an issuer failing to meet interest or principal payments, and non-systematic risk can be reduced through portfolio diversification.
Credit risk measures an issuer's default probability regarding debt service obligations. Non-systematic risk is company- or industry-specific and can be effectively managed and reduced through broad diversification.

Step-by-Step Solution

1
Define credit risk as it relates to debt securities.
Credit risk measures the danger of financial default by a specific debt issuer on interest or principal obligations.
It addresses issuer solvency rather than broader economic factors.
2
Evaluate the effect of diversification on non-systematic risks.
Non-systematic risks (business, financial, credit) are specific to single companies or industries and can be diluted through asset diversification.
Distributing capital across multiple sectors prevents isolated failures from crippling the entire portfolio.
3
Distinguish non-systematic/credit risk from systematic/interest-rate risk.
U.S. Treasuries possess negligible credit risk, and interest rate or market-wide changes represent systematic risk.
Systematic risk affects all securities in the market and cannot be diversified away.

Key Concept

Non-systematic risk is issuer-specific and can be mitigated via diversification, whereas credit risk specifically refers to default risk on debt obligations.
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Topics

Non-Systematic and Credit Risks

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