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Question

Difficulty: MediumSystematic and Market Risks

An investor maintains a fixed-income portfolio composed of fixed-rate corporate and municipal bonds distributed across twenty different issuers and industry sectors. If prevailing interest rates rise sharply across the economy, which of the following statements correctly evaluates the principal risk affecting this portfolio's market value?

  1. The portfolio will experience a drop in market value due to interest rate risk, a systematic risk that cannot be eliminated through issuer diversification.Answer
  2. B
    The portfolio's market value will remain unaffected because holding bonds across diverse issuers and sectors neutralizes interest rate risk.
  3. C
    The market value of the bonds will increase because bond prices move in tandem with rising market interest rates.
  4. D
    The portfolio's value declines primarily due to issuer credit risk, which can be fully removed while maintaining duration by reallocating to long-term U.S. Treasury bonds.

Answer

The portfolio will experience a drop in market value due to interest rate risk, a systematic risk that cannot be eliminated through issuer diversification.
Rising prevailing interest rates cause fixed-rate bond prices to fall across the entire market. Because interest rate risk is a form of systematic risk, it affects fixed-income products broadly and cannot be mitigated simply by spreading capital across multiple corporate and municipal issuers.

Step-by-Step Solution

1
Identify the economic event described in the scenario
Prevailing interest rates rise sharply across the economy.
Macroeconomic interest rate shifts impact fixed-income market valuations broad-scale.
2
Apply the fundamental relationship between interest rates and bond prices
Existing fixed-rate bond market prices decrease when rates increase.
Newly issued bonds offer higher yield, making existing lower-coupon bonds less attractive unless priced at a discount.
3
Evaluate the impact of diversification on systematic vs. non-systematic risk
Diversification across 20 issuers removes unsystematic credit risk, but interest rate risk remains.
Interest rate risk is a market-wide systematic risk that affects all fixed-income securities simultaneously.

Key Concept

Systematic Risk and Interest Rate Dynamics in Fixed-Income Portfolios
Estimated Time:1m 15s
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Topics

Systematic and Market Risks

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