Examkin

Question

Difficulty: MediumSystematic and Market Risks

A financial advisor is evaluating the risk exposure of a client's portfolio, which is diversified across 100 U.S. large-cap stocks and 50 corporate bonds. As macroeconomic conditions signal unexpected interest rate increases and elevated inflation, which of the following statements regarding the systematic risk of this portfolio are correct?

  1. Both the equity and bond holdings remain subject to systematic risks such as interest rate risk and purchasing power risk regardless of how many individual securities are added.Answer
  2. B
    Expanding the portfolio into 200 additional international equities will completely eliminate market risk through broad global asset allocation.
  3. Broad market index put options can be utilized as a hedging strategy to protect the equity portion against general market downturns.Answer
  4. D
    Reallocating the corporate bond portion into U.S. Treasury bonds will eliminate interest rate risk because Treasury securities carry no credit risk.

Answer

The portfolio remains exposed to systematic risks such as interest rate risk and purchasing power risk across both stock and bond holdings despite broad diversification, and broad market index put options can be used as a hedging strategy against market risk.
Systematic risks, including interest rate risk and purchasing power (inflation) risk, impact whole asset classes and cannot be eliminated by adding more securities to a portfolio. However, systematic market risk can be hedged using index put options, which increase in value as the general market declines.

Step-by-Step Solution

1
Distinguish between systematic and non-systematic risks.
Systematic risks (such as market risk, interest rate risk, and inflation risk) originate from macro-level economic factors and affect entire market segments.
Diversification across additional issuers reduces non-systematic (business-specific) risk, but cannot eliminate systematic risk factors.
2
Analyze how systematic factors impact equity and fixed-income assets.
Rising interest rates and elevated inflation negatively affect both equity valuations and fixed-rate bond prices across the portfolio.
Macroeconomic shifts exert systematic pressure on securities regardless of portfolio size.
3
Evaluate hedging mechanisms and security-level risk trade-offs.
Purchasing index put options protects equity value during broad market drops. Switching to U.S. Treasuries eliminates default risk but leaves interest rate risk intact.
Derivatives can hedge systematic market declines, whereas government bonds still experience price declines when interest rates rise.

Key Concept

Systematic risk (market, interest rate, and inflation risk) cannot be diversified away, but systematic market risk can be hedged using index options.
Estimated Time:1m 30s
Rate this question

Topics

Systematic and Market Risks

More questions from this topic