Module: | MODULE B: RISK MANAGEMENT
Q335: Consider the following statements regarding the components of market risk, specifically General Market Risk and Specific Market Risk, in a bank's investment portfolio:
1. General Market Risk refers to the risk of loss arising from adverse changes in the overall market interest rates or equity indices.
2. Specific Market Risk is associated with the price volatility of a specific security due to factors unique to its individual issuer.
3. A highly diversified portfolio completely eliminates General Market Risk while leaving Specific Market Risk unaffected.
2. Specific Market Risk is associated with the price volatility of a specific security due to factors unique to its individual issuer.
3. A highly diversified portfolio completely eliminates General Market Risk while leaving Specific Market Risk unaffected.
✅ Correct Answer: A
The correct answer is A. Statement 1 is correct: General Market Risk (or systematic risk) arises from macroeconomic factors affecting the entire market, such as shifts in the sovereign yield curve or broad equity market indices.
Statement 2 is correct: Specific Market Risk (or idiosyncratic/unsystematic risk) relates to the unique characteristics of the issuer, such as a downgrade in the issuer's credit rating, a management scandal, or an earnings miss, which affects only that specific security.
Statement 3 is incorrect: It states the exact opposite of portfolio theory.
Diversification significantly reduces or eliminates Specific Market Risk (since holding many uncorrelated assets cancels out individual issuer shocks), but it cannot eliminate General Market Risk, because macroeconomic factors affect all assets in the market systemically.
Statement 2 is correct: Specific Market Risk (or idiosyncratic/unsystematic risk) relates to the unique characteristics of the issuer, such as a downgrade in the issuer's credit rating, a management scandal, or an earnings miss, which affects only that specific security.
Statement 3 is incorrect: It states the exact opposite of portfolio theory.
Diversification significantly reduces or eliminates Specific Market Risk (since holding many uncorrelated assets cancels out individual issuer shocks), but it cannot eliminate General Market Risk, because macroeconomic factors affect all assets in the market systemically.