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Difficulty: HardSystematic and Market Risks

An investor holding a portfolio concentrated in fixed-rate corporate and municipal bonds seeks to mitigate the impact of unexpected long-term inflation on the portfolio's real purchasing power. To achieve this goal, the investor expands the portfolio from 15 bond holdings to over 300 distinct bond issues spanning multiple industries and geographic regions, while maintaining the same fixed-income asset allocation. Which of the following statements best evaluates the effectiveness of this strategy?

  1. The strategy fails to mitigate purchasing power risk because inflation is a systematic risk that erodes the real purchasing power of fixed coupon payments regardless of issuer diversification.Answer
  2. B
    The strategy successfully eliminates purchasing power risk because broad diversification across 300 different issuers neutralizes microeconomic inflation shocks across sectors.
  3. C
    The strategy converts systematic purchasing power risk into non-systematic credit risk, which can then be offset through sovereign yield guarantees.
  4. D
    The strategy reduces purchasing power risk because distributing cash flows across hundreds of coupon dates forces secondary market bond prices to rise when market yields increase.

Answer

The strategy fails to mitigate purchasing power risk because inflation is a systematic risk that erodes the real purchasing power of fixed coupon payments regardless of issuer diversification.
The correct answer accurately identifies that purchasing power (inflation) risk is a systematic risk inherent to fixed-income investments. Because inflation reduces the real value of fixed cash flows across the entire economy, spreading investments among 300 different bond issuers does not insulate the investor from purchasing power loss.

Step-by-Step Solution

1
Identify the specific risk type being targeted by the investor.
The risk in question is purchasing power (inflation) risk, which threatens the real value of fixed interest payments over time.
Understanding whether the risk is systematic or unsystematic determines the efficacy of asset diversification.
2
Classify purchasing power risk as systematic (market-wide) or unsystematic (business-specific).
Purchasing power risk is a systematic risk because inflationary pressures affect the economy as a whole and lower the real return of fixed-income instruments universally.
Systematic risks stem from broad macroeconomic forces and cannot be eliminated by adding more securities within the same asset class.
3
Evaluate the impact of expanding the portfolio from 15 to 300 bond issues.
Adding issuers reduces unsystematic credit/default risk, but leaves the portfolio's exposure to systematic inflation risk completely unchanged.
Fixed coupon rates continue to deliver fixed cash flows whose purchasing power diminishes equally during inflationary periods regardless of issuer diversity.

Key Concept

Systematic risks (such as market, interest rate, purchasing power/inflation, and currency risk) affect the entire market or asset class and cannot be eliminated through portfolio diversification.
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Topics

Systematic and Market Risks

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