Examkin

Question

Difficulty: HardSystematic and Market Risks

An investor maintains a portfolio broadly allocated across 250 individual domestic stocks spanning all primary industry sectors, alongside a selection of corporate bonds. In response to anticipated macroeconomic shifts and Federal Reserve policy adjustments, the investor plans to completely eliminate market-wide downside risk by expanding holdings to include international equities and additional debt issues. Which of the following statements best evaluates this strategy's effectiveness regarding systematic risk?

  1. The strategy will fail to eliminate systematic risk, as market-wide risks affect the entire financial system and cannot be diversified away regardless of portfolio expansion.Answer
  2. B
    The strategy will successfully remove systematic risk once security selection achieves complete cross-border and cross-industry asset distribution.
  3. C
    The strategy will insulate the bond portion from systematic risk because fixed-income securities are strictly exposed to non-systematic credit risk.
  4. D
    The strategy will convert the portfolio's systematic risk into reinvestment risk, which fully stabilizes market prices during economic contractions.

Answer

The strategy will fail to eliminate systematic risk because market-wide risks affect the entire economy and financial system, making them impossible to remove through diversification alone.
Systematic risk (also known as market risk or non-diversifiable risk) is driven by macroeconomic events such as interest rate changes, inflation, and recessions. Because these forces affect the overall market, adding more securities or asset classes will not eliminate systematic risk.

Step-by-Step Solution

1
Identify the nature of the risks present in the portfolio.
Systematic risks (such as market risk, interest rate risk, and purchasing power risk) stem from macroeconomic factors affecting all market participants.
Differentiating between systematic and non-systematic risk is required to evaluate hedging and diversification outcomes.
2
Evaluate the limits of asset diversification.
Diversification reduces non-systematic (business or credit) risk, but cannot eliminate systematic risk.
Market-wide downturns impact virtually all asset classes and sectors to varying degrees simultaneously.
3
Assess the investor's proposed strategy against systematic risk principles.
Adding more securities, sectors, or international equities does not remove exposure to broad systemic market declines.
Only hedging strategies (such as purchasing index options) can mitigate systematic risk, not asset diversification alone.

Key Concept

Non-diversifiability of Systematic Risk
Estimated Time:2m 0s
Rate this question

Topics

Systematic and Market Risks

More questions from this topic