Examkin

Question

Difficulty: MediumNon-Systematic and Credit Risks

An investor holds unsecured corporate debentures issued by an aviation components manufacturer. Following the loss of its primary defense contract, the manufacturer suffers severe financial distress, leading rating agencies to downgrade its debt from investment grade to speculative grade. Which type of risk has primarily materialized for the bondholder, and what is the primary strategy to mitigate this specific risk in a fixed-income portfolio?

  1. Credit risk, which can be effectively reduced through asset diversification across different issuers and industry sectors.Answer
  2. B
    Interest rate risk, which can be effectively reduced by increasing the portfolio's duration with longer-term debt obligations.
  3. C
    Systematic risk, which can be effectively reduced by holding the debentures until their scheduled maturity date.
  4. D
    Purchasing power risk, which can be effectively reduced by shifting the fixed-income capital entirely into U.S. Treasury bonds.

Answer

Credit risk, which can be effectively reduced through asset diversification across different issuers and industry sectors.
The correct response identifies credit risk, which is the possibility of financial distress or default by a specific debt issuer. Because credit risk is non-systematic (unique to a particular company or entity), spreading capital across multiple distinct issuers and industry sectors effectively minimizes the potential impact of any single issuer's downgrade or default.

Step-by-Step Solution

1
Identify the nature of the risk event described in the stem.
The corporate bond issue faces financial distress and a rating downgrade due to lost business revenue, which directly reflects issuer credit/default risk.
Credit risk is the risk that a debt issuer will default on interest or principal payments or suffer a credit rating downgrade.
2
Classify the risk as systematic or non-systematic.
Credit risk is non-systematic because it affects a specific corporate entity rather than the broad overall market.
Non-systematic risks stem from specific corporate operations, management decisions, or business challenges.
3
Determine the appropriate risk mitigation strategy.
Diversifying fixed-income holdings across various corporate issuers, municipalities, and government debt mitigates individual issuer credit exposure.
Non-systematic risks can be substantially reduced or eliminated by constructing a diversified portfolio.

Key Concept

Credit Risk & Non-Systematic Risk Mitigation
Estimated Time:1m 15s
Rate this question

Topics

Non-Systematic and Credit Risks

More questions from this topic