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Difficulty: MediumNon-Systematic and Credit Risks

An investor allocates a significant portion of their fixed-income portfolio to debt securities issued by a single biotechnology firm awaiting regulatory approval for its primary product. If the product fails to obtain approval, the issuer's financial stability may suffer, raising the probability of default on its debt. Which type of risk does this situation represent, and what is the primary strategy to mitigate it?

  1. Non-systematic business and credit risk, which can be mitigated through asset diversification across multiple issuers.Answer
  2. B
    Interest rate risk, which can be mitigated by holding the bonds to maturity regardless of the issuer's credit standing.
  3. C
    Systematic market risk, which can be mitigated by purchasing corporate bonds offering higher fixed coupon payments.
  4. D
    Inflation risk, which can be mitigated by reinvesting interest payments into debt securities with longer maturities.

Answer

Non-systematic business and credit risk, which can be mitigated through asset diversification across multiple issuers.
The correct answer identifies that risk stemming from a specific firm's operational outcome (such as a product failure) is non-systematic credit and business risk. Non-systematic risks are unique to a particular issuer and can be mitigated by spreading capital across multiple unrelated issuers.

Step-by-Step Solution

1
Identify the nature of the risk described in the scenario.
The risk is specific to a single company's product failure and potential debt default, which defines non-systematic business and credit risk.
Non-systematic risks are specific to individual issuers or industries rather than the overall market.
2
Determine the appropriate risk mitigation strategy.
Diversifying the portfolio across various issuers and sectors spreads company-specific risk.
Because non-systematic risk is uncorrelated across different issuers, diversification effectively reduces or eliminates it.

Key Concept

Non-systematic risk (business and credit risk) is issuer-specific and can be mitigated through diversification, unlike systematic market risk.
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Topics

Non-Systematic and Credit Risks

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