A pharmaceutical firm experiences an unexpected failure in a key clinical drug trial, prompting credit rating agencies to downgrade the firm's debt and causing a steep decline in its stock price. A financial advisor reviews the impact of this event on client portfolios. Which of the following statements regarding the risks illustrated in this scenario are correct?
- The sharp decline in the issuer's bond and equity values stems from business and credit risk, which are forms of non-systematic risk.Answer
- An investor can substantially mitigate this specific form of risk by allocating capital across a broadly diversified portfolio of un-correlated securities.Answer
- CThe primary cause of the bond's price decline in this scenario is market interest rate risk, which impacts all debt instruments equally regardless of credit rating.
- DBecause clinical trial outcomes reflect broader economic conditions, the resulting security losses represent market risk that cannot be diversified away.
Answer
The decline in security values stems from business and credit risk (non-systematic risks specific to the issuer), and this type of risk can be substantially mitigated through portfolio diversification.
The correct statements recognize that company-specific operational failures (such as clinical trial outcomes) and debt downgrades represent business and credit risks, which are non-systematic in nature. Furthermore, non-systematic risks can be effectively managed and reduced through asset diversification across multiple issuers and business sectors.
Step-by-Step Solution
Key Concept
Non-Systematic Risk vs. Systematic Risk and Diversification