NASAA Series 65, Uniform Investment Adviser Law ExaminationInvestment Vehicle CharacteristicsEasy
A portfolio manager is evaluating the credit risk associated with a client's holdings. The manager observes that a significant portion of the client's debt securities are issued by companies with lower credit ratings. What specific risk is the manager primarily concerned with?
- ADefault Risk
- BLiquidity Risk
- CMarket Risk
- DInterest Rate Risk
Show answer & explanationAnswer & explanation
Correct answer: A. Default Risk
Default risk, also known as credit risk, is the risk that an issuer will be unable to make its promised interest payments or repay the principal amount at maturity. Lower credit ratings directly indicate higher default risk.
Why the other options are wrong
- B. Liquidity risk is the risk that an investment cannot be easily bought or sold without a significant loss in value, not directly related to credit ratings.
- C. Market risk is the risk of losses due to factors affecting the overall market, not specific to an issuer's ability to pay.
- D. Interest rate risk refers to the potential for bond prices to fall when interest rates rise, not directly linked to the issuer's creditworthiness.
Default Risk (Credit Risk)
The risk that a bond issuer will be unable to make its promised interest payments or repay the principal amount at maturity.
- Higher for bonds issued by companies or governments with lower credit ratings.
- Investors demand higher yields (risk premium) for bonds with higher default risk.
- Can lead to partial or total loss of invested capital.
- Assessed by credit rating agencies like S&P, Moody's, Fitch.
Memory trick: Bonds face DIM Lags: Default, Interest Rate, Market, Liquidity.