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Difficulty: MediumSystematic and Market Risks

An investor maintains a well-diversified equity portfolio spread across multiple domestic industry sectors. Following an unexpected benchmark interest rate hike by the Federal Reserve, broad equity markets experience a downturn, resulting in a decline in the overall market value of the investor's portfolio. The investor's registered representative suggests purchasing stocks from thirty additional companies in unrepresented domestic sectors to completely protect the portfolio from future market downturns caused by rate increases. Which of the following statements best evaluates the registered representative's recommendation?

  1. The recommendation will fail to protect the portfolio because interest rate changes trigger systematic risk, which impacts the entire market and cannot be eliminated through diversification.Answer
  2. B
    The recommendation will successfully eliminate the portfolio's vulnerability provided the newly acquired stocks have low historical price volatility.
  3. C
    The recommendation is unnecessary because interest rate changes only impact debt instruments by altering default risk, leaving equity portfolio valuations unaffected.
  4. D
    The recommendation will succeed because adding securities across additional industry sectors converts systematic market risk into unsystematic business risk.

Answer

The recommendation will fail to protect the portfolio because interest rate changes trigger systematic risk, which impacts the entire market and cannot be eliminated through diversification.
Interest rate risk is a primary subtype of systematic risk. Macroeconomic policy changes by the Federal Reserve impact economic activity, corporate borrowing costs, and general market valuation multiples across all sectors. Because systematic risk influences the broader market as a whole, it cannot be eliminated or diversified away simply by adding more individual equity positions.

Step-by-Step Solution

1
Identify the type of risk described in the scenario.
The risk stems from a macroeconomic event (Federal Reserve interest rate hike) impacting the broad market.
Macroeconomic factors affecting the overall market represent systematic risk.
2
Evaluate the effect of portfolio diversification on systematic risk.
Diversification spreads risk across specific issuers (unsystematic risk) but cannot hedge or remove market-wide systematic risk factors like interest rate risk.
Systematic risks affect all market participants simultaneously regardless of how many individual stocks or sectors are added.
3
Select the option that accurately describes the limitations of diversification against systematic risk.
The statement pointing out that interest rate risk is systematic and cannot be eliminated by adding more stocks is correct.
HEDGING strategies (such as index options) rather than diversification are required to manage systematic market risk.

Key Concept

Systematic risk (market risk, interest rate risk, inflation risk) affects the overall market and cannot be eliminated through portfolio diversification.
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Topics

Systematic and Market Risks

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