A pharmaceutical company faces severe financial distress following the unexpected rejection of its primary drug candidate by regulatory authorities, causing the market value of its corporate debentures to drop sharply. An investor holding a broad basket of corporate bonds issued across multiple distinct business sectors experiences minimal impact on total portfolio value. This scenario best illustrates the mitigation of which type of risk through diversification?
- Business risk, because non-systematic risk is specific to a single firm or industry and can be reduced by spreading investments across varied issuers.Answer
- BInterest rate risk, because bond price declines caused by regulatory decisions can be eliminated by holding fixed-income securities with varying maturity dates.
- CSystematic market risk, because diversification across multiple corporate bond issuers eliminates market-wide price volatility.
- DPurchasing power risk, because inflation impacts individual corporate issuers unequally based on product failure.
Answer
Business risk, because non-systematic risk is specific to a single firm or industry and can be reduced by spreading investments across varied issuers.
Business risk is a non-systematic (unsystematic) risk inherent to a specific issuer's business operations or sector. Because it is unique to the individual company, holding a diversified portfolio of securities across different sectors isolates the investor from severe losses when any single issuer experiences negative events.
Step-by-Step Solution
Key Concept
Non-Systematic (Business/Credit) Risk and Diversification