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Question

Difficulty: MediumSystematic and Market Risks

A retail investor holds a fixed-income portfolio diversified across fifty different U.S. corporate bond issues spanning multiple industrial sectors and credit ratings. Which of the following statements regarding the systematic risk exposures of this portfolio are correct? (Select all that apply.)

  1. Rising prevailing interest rates will depress the market values of existing fixed-income holdings across the portfolio regardless of issuer diversification.Answer
  2. Purchasing power risk remains present across the holdings because inflation erodes real returns across the entire bond market.Answer
  3. C
    Adding more corporate bond issuers to the portfolio will eliminate its exposure to interest rate fluctuations through asset diversification.
  4. D
    An inverted yield curve signals an impending macroeconomic expansion that shields long-term bonds from market risk.

Answer

The correct statements are that rising prevailing interest rates depress market values across the portfolio regardless of diversification, and purchasing power risk remains present because inflation erodes real returns across the fixed-income market.
Interest rate risk and purchasing power (inflation) risk are fundamental types of systematic risk. Because systematic risk stems from broad macroeconomic forces, it affects the entire fixed-income market and cannot be eliminated by diversifying across multiple issuers or corporate sectors.

Step-by-Step Solution

1
Identify the type of risks described in the scenario.
The portfolio holds fixed-income securities across multiple corporate issuers.
Understanding asset class characteristics helps categorize risk factors as systematic or unsystematic.
2
Evaluate the impact of diversification on systematic risk.
Diversification across 50 corporate issuers mitigates unsystematic (credit/default) risk but leaves systematic risks (interest rate risk, inflation risk) unchanged.
Systematic risks stem from macro-level economic factors that impact the entire market segment simultaneously.
3
Determine the validity of each statement.
Statements highlighting interest rate sensitivity and inflation risk are correct, whereas statements claiming diversification removes interest rate risk or misinterpreting inverted yield curves are incorrect.
Interest rate and purchasing power risks are non-diversifiable systematic risks inherent to fixed-income portfolios.

Key Concept

Systematic Risk and Limits of Diversification
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Topics

Systematic and Market Risks

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