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Difficulty: MediumNon-Systematic and Credit Risks

An investor holds a portfolio heavily concentrated in corporate debentures issued by a single mid-sized logistics firm. After a major contract loss, credit rating agencies downgrade the issuer's debt from investment grade to junk status, causing the bond prices to fall significantly. Which of the following correctly identifies the primary risk demonstrated in this scenario, and how can an investor best mitigate it?

  1. Credit risk, which can be mitigated by diversifying investments across multiple issuers and sectors.Answer
  2. B
    Interest rate risk, which can be mitigated by matching the duration of the debt securities to the investor's time horizon.
  3. C
    Systematic market risk, which can be completely eliminated by diversifying across various bond maturities.
  4. D
    Purchasing power risk, which can be mitigated by holding the corporate debentures until maturity.

Answer

Credit risk, which can be mitigated by diversifying investments across multiple issuers and sectors.
The correct answer identifies credit risk as the primary risk when an individual issuer experiences business difficulties and debt downgrades. Because credit risk is a non-systematic risk unique to a specific firm, it can be mitigated effectively through diversification across multiple issuers and sectors.

Step-by-Step Solution

1
Identify the nature of the risk presented in the scenario.
The price decline stems from a specific company's commercial difficulties and a resulting credit rating downgrade.
Risk tied directly to the financial strength and debt repayment capacity of an individual issuer is classified as credit (default) risk.
2
Determine the proper risk management technique for this category of risk.
Because credit risk is non-systematic (business-specific), asset diversification across various issuers and industries neutralizes its impact on a portfolio.
Diversification ensures that adverse events affecting a single firm will not severely impair the total value of the overall portfolio.

Key Concept

Credit risk is a non-systematic risk specific to an individual issuer that can be minimized through portfolio diversification.
Estimated Time:1m 15s
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Topics

Non-Systematic and Credit Risks

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