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Question

Difficulty: HardSystematic and Market Risks

During a period of rapidly accelerating inflation, an investor reallocates their capital into a broad fixed-income portfolio comprising 50 distinct long-term corporate bonds across various market sectors. Which of the following statements correctly evaluates the primary risk remaining in this portfolio?

  1. The portfolio remains exposed to purchasing power risk, a systematic risk that cannot be eliminated through diversification across multiple bond issuers.Answer
  2. B
    The portfolio has successfully eliminated systematic risk because the holdings are spread across 50 non-correlated corporate issuers.
  3. C
    The portfolio is insulated from rising interest rates because existing bond market prices increase when prevailing inflation drives yields higher.
  4. D
    The portfolio's dominant vulnerability is non-systematic credit risk, which causes the macroeconomic yield curve to invert and boost long-term prices.

Answer

The portfolio remains exposed to purchasing power risk, a systematic risk that cannot be eliminated through diversification across multiple bond issuers.
Purchasing power (inflation) risk is a key subtype of systematic risk. Fixed-rate debt instruments pay fixed interest streams that lose real purchasing power as inflation accelerates. Because market-wide macroeconomic shifts affect all fixed-income instruments, diversifying across 50 corporate issuers lowers non-systematic (credit/default) risk but leaves systematic purchasing power risk intact.

Step-by-Step Solution

1
Differentiate between systematic and non-systematic risk factors in the scenario.
Systematic risks (such as purchasing power risk and interest rate risk) impact the broader market, whereas non-systematic risks (such as credit/default risk) are specific to individual corporate issuers.
Understanding the boundary of diversification is essential to evaluating risk exposure.
2
Evaluate the impact of holding 50 distinct corporate bonds across multiple sectors.
Spreading investment across 50 issuers effectively mitigates business and credit risk (non-systematic risk).
Diversification reduces isolated issuer defaults from significantly harming total portfolio value.
3
Analyze how inflation affects fixed-income securities universally.
Rising inflation erodes the real value of fixed interest payments and drives market interest rates higher, depressing fixed-income market values across the entire asset class.
Purchasing power risk affects all fixed-rate bonds regardless of how many issuers are included in the portfolio.

Key Concept

Systematic Risk and Non-Diversifiability of Inflation/Purchasing Power Risk
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Topics

Systematic and Market Risks

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