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Difficulty: HardNon-Systematic and Credit Risks

An institutional investor holds a position in short-term commercial paper issued by a heavy machinery manufacturing firm. Following a prolonged labor union strike that forced plant shutdowns, a major credit rating agency lowered the firm's prime debt rating from P-1 to P-3, prompting market concerns regarding the firm's liquidity and ability to roll over short-term debt at maturity. Which of the following risks has primarily increased for this debt holding?

  1. Credit riskAnswer
  2. B
    Interest rate risk
  3. C
    Market risk
  4. D
    Purchasing power risk

Answer

Credit risk
Credit risk (also known as default risk) is a non-systematic risk specific to a given issuer. It represents the likelihood that the borrowing corporation will experience financial difficulty, resulting in credit rating downgrades or an inability to make timely principal and interest payments. In this scenario, the labor disruption and subsequent rating downgrade directly impair the issuer's creditworthiness.

Step-by-Step Solution

1
Identify the cause of the risk event in the scenario
The risk event stems from a firm-specific labor strike leading to plant shutdowns and a credit rating downgrade by a rating agency.
Evaluating whether the source of risk is company-specific (non-systematic) or economy-wide (systematic) determines the broad risk classification.
2
Map the specific impact on the bondholder to the correct risk category
A credit rating downgrade directly reflects heightened probability of default or liquidity distress regarding repayment of principal and interest.
Credit risk directly measures the issuer's financial capability to honor its debt obligations as scheduled.

Key Concept

Credit Risk vs. Market Risk
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Topics

Non-Systematic and Credit Risks

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