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Difficulty: MediumNon-Systematic and Credit Risks

A financial advisor is reviewing a retail investor's portfolio, which is heavily concentrated in corporate debt securities issued by a single industrial manufacturing firm. Which of the following statements regarding the risks associated with this concentrated portfolio are CORRECT?

  1. The portfolio is heavily exposed to business risk, which can be significantly reduced by diversifying holdings across different issuers and industry sectors.Answer
  2. B
    The credit risk of the issuer can be completely eliminated if the investor holds the corporate bonds until their scheduled maturity date.
  3. A rating agency downgrade of the manufacturer's credit rating represents a non-systematic credit event that adversely impacts the market value of these bonds.Answer
  4. D
    The principal danger of concentrating funds in this single issuer is interest rate risk, which affects all fixed-income securities in the market equally.

Answer

The correct statements are that the portfolio is exposed to business risk which can be reduced through diversification, and that a credit rating downgrade of the issuing firm is a non-systematic credit event that depresses bond market values.
Non-systematic risks, such as business risk and credit risk, are specific to a single issuer. Because these risks are firm-specific, they can be reduced through portfolio diversification. Furthermore, a credit rating downgrade directly reflects an increase in the issuer's default risk, which is a non-systematic event that negatively impacts the market price of those specific bonds.

Step-by-Step Solution

1
Analyze the nature of single-issuer risk exposure.
Concentrating assets in a single issuer introduces non-systematic (unsystematic) risks—such as business risk and credit risk—that stem directly from that company's financial and operational health.
Non-systematic risks are company-specific and distinct from broad macroeconomic market forces.
2
Evaluate risk mitigation techniques for non-systematic risks.
Diversifying the portfolio across multiple issuers and industry sectors effectively minimizes non-systematic risk. Holding bonds to maturity does not eliminate default risk if the issuer becomes insolvent.
Diversification spreads issuer risk, whereas holding to maturity only avoids selling at a loss due to interest rate fluctuations, not issuer default.
3
Distinguish non-systematic credit events from systematic market risks.
Credit rating downgrades are non-systematic events specific to the issuer, while interest rate risk is systematic and impacts the entire fixed-income market.
Systematic risks affect all market participants, whereas credit downgrades reflect an individual issuer's deteriorating ability to service debt.

Key Concept

Non-Systematic Risk and Credit Risk Characteristics
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Topics

Non-Systematic and Credit Risks

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