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Difficulty: MediumNon-Systematic and Credit Risks

An investor holds both a 10-year corporate debenture issued by a manufacturing company facing operating losses and a 1-year U.S. Treasury bill. The investor is reviewing how different economic events impact each holding. Which of the following statements correctly differentiates the non-systematic credit risk of the corporate bond from the risks affecting the U.S. Treasury bill?

  1. The corporate bond is subject to credit risk stemming from the issuer's potential inability to meet debt obligations, whereas the U.S. Treasury bill carries negligible credit risk but remains exposed to systematic risks such as purchasing power risk.Answer
  2. B
    The U.S. Treasury bill carries primary credit risk driven by changes in benchmark interest rates, whereas the corporate bond's risk is entirely systematic and cannot be mitigated by diversification.
  3. C
    The corporate bond's credit risk can be completely eliminated by purchasing equal allocations of bonds issued by competing companies within the same manufacturing sector.
  4. D
    The U.S. Treasury bill is primarily exposed to financial default risk, whereas the corporate bond is subject exclusively to interest rate risk.

Answer

The corporate bond is subject to credit risk stemming from the issuer's potential inability to meet debt obligations, whereas the U.S. Treasury bill carries negligible credit risk but remains exposed to systematic risks such as purchasing power risk.
Non-systematic risk (such as credit or business risk) is specific to an individual issuer. The manufacturing company's financial distress creates credit risk (default risk) for its corporate debentures. In contrast, U.S. Treasury bills carry virtually no credit risk because they are backed by the full faith and credit of the U.S. government. However, U.S. Treasury securities remain subject to systematic risks—such as inflation (purchasing power) risk—which affect the broader market.

Step-by-Step Solution

1
Identify the nature of credit risk (non-systematic risk)
Credit risk (or default risk) is the risk that a specific issuer will fail to pay principal or interest when due. This risk is unique to the issuer and can be reduced through diversification.
Corporate debentures rely on the issuer's cash flow and creditworthiness, making them susceptible to business and credit risk.
2
Evaluate the risk profile of U.S. Treasury bills
U.S. Treasury bills are backed by the U.S. government, giving them virtually zero credit (default) risk. However, they are still vulnerable to systematic market risks like purchasing power (inflation) risk.
Systematic risks affect all market participants and cannot be avoided simply by holding government-backed debt.
3
Compare the two instruments to determine the correct statement
The statement accurately identifying credit risk in the corporate debt and systematic risk exposure in the U.S. Treasury bill is correct.
Conflating interest rate changes or systematic market risks with default risk is a common conceptual error.

Key Concept

Non-Systematic Credit Risk vs. Systematic Market Risk
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Topics

Non-Systematic and Credit Risks

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