Examkin

Question

Difficulty: MediumNon-Systematic and Credit Risks

An investor holds short-term commercial paper issued by a regional airline company. Following significant operational losses, a credit rating agency downgrades the issuer's credit rating, raising concerns regarding the firm's ability to fulfill its scheduled principal and interest payments. Which of the following risks is directly highlighted in this scenario, and how can an investor best mitigate it?

  1. Credit risk, which can be mitigated by diversifying investments across multiple issuers in different industries.Answer
  2. B
    Interest rate risk, which can be mitigated by purchasing debt instruments with longer maturity dates.
  3. C
    Systematic market risk, which can be eliminated by holding the debt security until its scheduled maturity.
  4. D
    Call risk, which can be mitigated by exchanging commercial paper for preferred equity securities.

Answer

Credit risk, which can be mitigated by diversifying investments across multiple issuers in different industries.
Credit risk represents the possibility that a borrower will fail to make required interest or principal payments on its debt obligations. Because credit risk is non-systematic (unique to the specific issuer), investors can mitigate it effectively by diversifying their fixed-income holdings across various issuers, sectors, and asset classes.

Step-by-Step Solution

1
Identify the primary risk associated with an issuer's operational distress and rating downgrade.
The possibility that an issuer will default on debt service payments (principal or interest) is classified as credit risk.
Credit risk evaluates the financial solvency and repayment capacity of a specific issuing entity.
2
Classify the risk as systematic or non-systematic.
Credit risk is non-systematic because it stems from issuer-specific business conditions rather than overall economic markets.
Non-systematic risks affect individual companies or narrow sectors independently of general market trends.
3
Determine the effective risk mitigation technique.
Spreading capital across diverse debt issuers and business sectors reduces exposure to single-issuer default.
Asset diversification isolates individual firm credit defaults so they do not devastate the entire portfolio.

Key Concept

Non-Systematic Credit Risk and Mitigation via Diversification
Rate this question

Topics

Non-Systematic and Credit Risks

More questions from this topic