Inflation

Legislation changes the tax treatment of dividends for all taxpayers, and dividend-paying stocks across every industry fall. This exposure is best classified as:

1. A.Business risk, because the affected companies must now reconsider their payout policies.Wrong. Business risk concerns how well a particular firm runs its operations, not an alteration of the tax code.
2. B.Nonsystematic risk, because only companies that pay dividends were affected by the change.Wrong. The affected group spans every industry, so no amount of spreading across sectors avoids it.
3. C.Credit risk, because the change reduces the cash ultimately available to shareholders.Wrong. Credit risk concerns an issuer's ability to service its debts, which a dividend tax change does not determine.
4. D.Systematic risk, because a change in law reaches the entire market at the same time.Correct. Legislative and political risk is market-wide by nature and cannot be diversified away.

Why: Systematic risk covers the influences that move broad markets: interest rates, inflation, recession, war, and changes in law and regulation. A tax change applying to all dividend-paying shares reaches across industries, so a portfolio spread over many sectors is exposed just the same. Nonsystematic risk is tied to a particular issuer or a narrow group, which is why adding unrelated holdings dilutes it. Had the legislation targeted one industry alone, a broadly spread portfolio would have absorbed only a fraction of the impact.

Prices rise much faster than anticipated over the life of a long-term fixed-rate corporate bond. Which statement best describes the effect on the bondholder?

1. A.The issuer must raise the coupon payments to preserve the holder's purchasing power.Wrong. A fixed coupon is fixed, and nothing in the indenture adjusts it for changes in the price level.
2. B.The holder benefits, because a fixed coupon gains value as the price level rises.Wrong. This states the relationship backwards, since rising prices erode what any fixed payment can buy.
3. C.The holder is harmed, because each fixed coupon buys less than it did at issuance.Correct. Purchasing power risk falls hardest on long-dated fixed payments, whose real value shrinks as prices climb.
4. D.The holder is unaffected, because the principal will be repaid in full at maturity.Wrong. Repayment in full is nominal, and the same number of dollars returns less real value after a stretch of high inflation.

Why: A fixed-rate bond promises a stream of unchanging dollar payments, so its real value depends entirely on what those dollars will buy. When inflation runs above what was expected at issuance, each coupon and the final principal payment buy less than the holder bargained for. This is purchasing power risk, and it grows with maturity because more payments lie further in the future. A floating-rate note or an inflation-adjusted security would shift much of that exposure away from the holder.

An investor holds bonds from thirty unrelated issuers across many industries, and inflation then accelerates across the whole economy. How is the resulting erosion of her real return classified?

1. A.Nonsystematic, because each issuer's ability to pay is affected to a different degree.Wrong. What is eroding is the real value of the payments, which is independent of any issuer's finances.
2. B.Nonsystematic, because further diversification across issuers would reduce the exposure.Wrong. More issuers simply means more streams of fixed payments, every one of them eroded by the same inflation.
3. C.Systematic, because a general rise in prices erodes every fixed payment at once.Correct. Purchasing power risk arises from an economy-wide condition and reaches every fixed-income holding together.
4. D.Systematic, but only for issuers whose costs rise faster than their revenues do.Wrong. That describes business risk at particular firms, a separate exposure that diversification does address.

Why: Systematic risks are driven by conditions affecting the whole market or economy, which is why they cannot be diversified away. Inflation is exactly such a condition, reducing what every fixed payment buys whoever the issuer happens to be. Spreading across thirty issuers protects against one of them defaulting, a nonsystematic exposure, and does nothing about the general price level. An investor who wants to address this has to change the type of instrument, moving toward inflation-adjusted or floating-rate securities.

Celeste Diaz earns a nominal 8.40% on a $133,357 portfolio while inflation is 3.90%. Using the exact multiplicative relationship, what is the real return?

1. A.12.30%This adds inflation to nominal return, which moves in the wrong direction.
2. B.4.50%This uses the common subtraction approximation rather than the exact calculation requested.
3. C.4.33%This uses the exact relationship between nominal growth and inflation.
4. D.46.43%This forms a ratio of the two percentages rather than adjusting growth factors.

Why: The exact real return divides the growth factor of the nominal return by the inflation growth factor and subtracts one. Simple subtraction is an approximation and can differ from the exact answer.