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Difficulty: HardNon-Systematic and Credit Risks

An investor's portfolio consists primarily of long-term uncollateralized debentures issued by a biotech firm. Following the unexpected cancellation of the firm's main clinical trials, rating agencies downgrade the bonds from investment grade to speculative grade, causing their market value to drop significantly while benchmark interest rates set by the Federal Reserve remain unchanged. Which of the following best categorizes the specific risk that caused this decline in bond value?

  1. Credit risk, because the downgrade reflects an increase in the likelihood that the issuer will default on its debt obligations.Answer
  2. B
    Interest rate risk, because long-term debt securities always suffer price drops whenever bond market yields fluctuate.
  3. C
    Systematic market risk, because general economic downturns reduce the market value of all fixed-income asset classes simultaneously.
  4. D
    Legislative risk, because Federal Reserve monetary policy decisions directly restricted the firm's capital raising abilities.

Answer

Credit risk, because the downgrade reflects an increase in the likelihood that the issuer will default on its debt obligations.
The correct answer identifies credit risk as the source of the price decline. Credit risk (also known as default risk) is a non-systematic risk specific to an individual corporate or municipal issuer. When an issuer suffers an operational setback—such as a cancelled drug trial—its financial condition deteriorates, prompting rating agencies to downgrade its debt and market participants to demand higher yield spreads, driving the bond price down regardless of general interest rate stability.

Step-by-Step Solution

1
Analyze the cause of the bond's price decline in the scenario.
The price drop stems from a firm-specific event (clinical trial cancellation) leading to a rating downgrade.
Determines whether the risk is systematic (market-wide) or non-systematic (issuer-specific).
2
Evaluate macro variables mentioned in the stem.
Benchmark interest rates remained unchanged, eliminating interest rate risk as the driving factor.
Distinguishes market/interest rate risk from issuer default risk.
3
Identify the risk classification.
The financial inability or reduced capacity of an issuer to fulfill contractual bond obligations is defined as credit/default risk.
Matches the scenario to the exact Securities Industry Essentials (SIE) risk definition.

Key Concept

Non-Systematic and Credit Risks
Estimated Time:1m 15s
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Topics

Non-Systematic and Credit Risks

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