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Difficulty: MediumNon-Systematic and Credit Risks

An investor holds a fixed-income portfolio heavily concentrated in debt securities issued by a single national restaurant chain. Following unexpected supply chain failures and falling customer traffic, rating agencies downgrade the chain's debt from investment grade to speculative grade. Which type of risk does this downgrade represent, and how can an investor best manage this specific risk in a portfolio?

  1. Credit risk, which can be reduced by diversifying holdings across multiple issuers in different industries.Answer
  2. B
    Interest rate risk, which can be reduced by extending the duration of the fixed-income holdings.
  3. C
    Systematic market risk, which can be eliminated by allocating assets across a wide variety of corporate bonds.
  4. D
    Legislative risk, which can be eliminated by holding only high-yield corporate debt instruments.

Answer

Credit risk, which can be reduced by diversifying holdings across multiple issuers in different industries.
A debt rating downgrade caused by issuer-specific operational challenges is a direct example of credit risk. Because credit risk is a non-systematic risk, investors can manage and reduce it by diversifying their portfolio across different issuers and economic sectors.

Step-by-Step Solution

1
Identify the nature of the risk described in the scenario.
The financial decline and rating downgrade stem from issuer-specific operational issues (supply chain and customer loss), which represents credit (default) risk.
Credit risk refers specifically to the financial failure or rating degradation of an individual issuing entity.
2
Determine whether the risk is systematic or non-systematic.
Credit risk is a non-systematic (unsystematic) risk unique to a specific firm or issuer.
Non-systematic risks arise from company-specific factors rather than macroeconomic market-wide factors.
3
Identify the appropriate risk mitigation strategy.
Non-systematic risk can be significantly reduced by diversifying investments across different issuers and industry sectors.
Portfolio diversification spreads exposure so that the failure or downgrade of a single issuer does not severely impact overall portfolio value.

Key Concept

Credit risk is a non-systematic risk tied to the financial strength of a specific issuer and can be mitigated through asset diversification.
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Topics

Non-Systematic and Credit Risks

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