An investor holds a portfolio exclusively composed of long-term U.S. Treasury bonds and is concerned about the impact of unexpected surges in national inflation over a ten-year holding period. Which statement correctly identifies the systematic risk facing this investor and explains why diversification fails to eliminate it?
- The portfolio primarily faces purchasing power risk, which cannot be eliminated through diversification because inflation broadly degrades the real purchasing power of fixed cash flows across the entire economy.Answer
- BThe portfolio primarily faces default risk, which can be eliminated by reallocating funds into high-grade corporate bonds across diverse market sectors.
- CThe portfolio primarily faces market risk, which can be completely neutralized by spreading holdings across a broader selection of federal agency debt securities.
- DThe portfolio primarily faces interest rate risk, which causes bond principal market values to appreciate when market interest rates rise.
Answer
The portfolio primarily faces purchasing power risk, which cannot be eliminated through diversification because inflation broadly degrades the real purchasing power of fixed cash flows across the entire economy.
Purchasing power risk (inflation risk) is a systematic risk that affects all fixed cash flow instruments. Rising inflation lowers the real buying power of fixed coupon payments and principal redemption values. Because systematic risk impacts the entire market simultaneously, expanding holdings within fixed-income securities cannot diversify away this risk.
Step-by-Step Solution
Key Concept
Purchasing Power Risk and Non-Diversifiability of Systematic Risk
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