Legislative Risk

During a downturn, federal income tax receipts fall and unemployment benefit payments rise without Congress enacting anything new. This effect is best described as:

1. A.Monetary policy operating through the reserves of the banking system.Wrong. Neither the tax receipts nor the benefit payments involve reserves, credit conditions or any action by the Fed.
2. B.Discretionary fiscal policy enacted in response to the business cycle.Wrong. Discretionary means a new law or appropriation, and by hypothesis Congress enacted nothing.
3. C.An automatic stabilizer built into fiscal programs already in force.Correct. Existing tax and benefit rules cushion demand automatically as incomes and employment fall.
4. D.A leading indicator signaling the coming phase of the business cycle.Wrong. These flows respond to a downturn already under way rather than pointing ahead to one.

Why: Fiscal policy operates in two modes. Discretionary policy requires a fresh decision, such as enacting a tax cut or appropriating money for a program. Automatic stabilizers are built into laws already on the books: a progressive income tax collects less as incomes fall, and benefit programs pay out more as unemployment rises, both without any vote. The effect cushions the downturn immediately, which is why it escapes the legislative delay that dogs discretionary action.

Rosalind holds a federally tax-exempt municipal bond fund purchased chiefly for the exemption. Her representative notes that one risk of the position has nothing to do with the credit of the issuers or the direction of interest rates. That risk is BEST described as:

1. A.Credit risk, because municipalities can default on their obligations.Credit risk is real for municipal issuers but the stem excludes issuer credit from the answer.
2. B.Reinvestment risk, because coupons must be reinvested at prevailing rates.Reinvestment risk is a rate-driven exposure, which the stem also excludes.
3. C.Legislative risk, because the tax exemption that justifies the position exists only by statute and can be changed.Correct. The value of the exemption depends on tax law, so a change in law is the distinct risk here.
4. D.Currency risk, because municipal issuers borrow in several currencies.Domestic municipal bonds are denominated in dollars, so currency risk is not implicated.

Why: Legislative or political risk is the risk that a change in law alters the economics of an investment. For a municipal bond fund the tax exemption itself is a creature of statute; a reduction in marginal tax rates or a change in the treatment of municipal interest would reduce the after-tax advantage that justified the purchase, and prices would adjust accordingly.

A political upheaval halts trading in one country's market. Consider a fund invested only in that country and a global fund with a small allocation there. How is the exposure classified for each?

1. A.Systematic for both funds, because political events are market-wide by their nature.Wrong. The global fund's other holdings were untouched, so its exposure was diluted rather than unavoidable.
2. B.Nonsystematic for both funds, because only a single country was affected.Wrong. The single-country fund could hold nothing outside that market, so nothing was available to dilute the event.
3. C.Nonsystematic for the single-country fund and systematic for the global fund.Wrong. This reverses the analysis by attaching the unavoidable label to the more broadly spread portfolio.
4. D.Systematic for the single-country fund and nonsystematic for the global fund.Correct. Whether a risk can be diversified away depends on what the portfolio is permitted to hold.

Why: Systematic and nonsystematic are not fixed labels attached to events; they describe whether a particular portfolio could have avoided the exposure. For a fund restricted to one country, that country's politics are a common factor running through every holding, so the risk is unavoidable within the mandate. For a global fund the same event touches one slice while the rest of the portfolio absorbs it, which is the definition of a diversifiable exposure. This is why a classification question must always be answered relative to a specified portfolio.