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Difficulty: Very hardSystematic and Market Risks

An investor holds a fixed-income portfolio consisting of 150 investment-grade corporate bonds spanning multiple business sectors. Following a series of aggressive benchmark interest rate hikes by the Federal Reserve, the portfolio experiences a uniform 12% decline in market value, even though all bond issuers retain top-tier credit ratings with zero defaults. Which of the following statements accurately explains why further diversifying the portfolio failed to prevent this loss, and identifies a valid hedging strategy?

  1. Diversification only mitigates unsystematic risk such as issuer credit risk, whereas interest rate risk is a systematic risk affecting all fixed-income securities that requires hedging tools such as index or yield-based options.Answer
  2. B
    Expanding diversification to over 300 corporate issuers would have eliminated the decline by completely insulating the portfolio against broader market fluctuations.
  3. C
    The market value decline was caused by default risk rather than market risk, so substituting corporate bonds with high-yield debt would have stabilized portfolio prices.
  4. D
    Rising benchmark interest rates drive up prevailing yields, which directly causes the market values of existing fixed-income securities to increase proportionally.

Answer

Diversification only mitigates unsystematic risk such as issuer credit risk, whereas interest rate risk is a systematic risk affecting all fixed-income securities that requires hedging tools such as index or yield-based options.
Interest rate risk is a non-diversifiable systematic risk that impacts all fixed-income securities when prevailing interest rates rise. Because diversification across issuers only eliminates unsystematic (specific) risks like credit or business risk, expanding the number of corporate bonds cannot prevent market-wide price erosion. Investors must use derivative hedging instruments, such as interest rate or index options, to protect against systematic downturns.

Step-by-Step Solution

1
Identify the primary source of the portfolio's loss.
The loss occurred due to rising benchmark interest rates across the economy, which is interest rate risk (a subtype of systematic risk).
Since issuer credit ratings remained strong and no defaults occurred, credit (non-systematic) risk was not the cause.
2
Evaluate the limitation of diversification on systematic risk.
Adding more bond holdings reduces unsystematic risk (business/credit risk), but has no effect on systematic risk.
Systematic risk stems from macroeconomic factors affecting all market participants simultaneously.
3
Determine an appropriate hedging strategy for systematic market risk.
Systematic risk must be managed using portfolio-level hedging instruments, such as index put options, yield-based options, or financial futures.
Derivatives allow investors to offset market-wide price declines without selling underlying assets.

Key Concept

Systematic Risk and Diversification Limits
Estimated Time:1m 45s
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Topics

Systematic and Market Risks

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