Capital Allocation Line (CAL) and Capi ...
We form a capital allocation line when we combine a risky asset portfolio... Read More
Systematic risk is inherent in the overall market and cannot be avoided. Non-systematic risk is limited to a particular asset class or security and can be avoided through appropriate portfolio diversification.
Systematic Risk
When you invest in a market, you face systematic risk. This risk is tied to market conditions like interest rates, inflation, and politics, among others. You can’t escape systematic risk, but if you use leverage, it can make it even riskier.
Non-systematic Risk
Non-systematic risk is limited to a particular asset class or security and is a function of the “idiosyncrasies” of a particular asset. Investors can avoid non-systematic risk through portfolio diversification. A diversified portfolio reduces exposure or reliance on any one underlying security or asset class.
Pricing of Risk
When an asset has both systematic and non-systematic risk, and we expect to be compensated for both, it makes sense to diversify. Diversification means spreading your investments across different assets that don’t move together. This way, you can reduce or eliminate the non-systematic risk, leaving you with only the systematic risk.
Even if an investor eliminates non-systematic risk, they wouldn’t be compensated. If they kept adding more non-systematic risk, they’d eventually get zero expected return. So, we can’t assume investors will be rewarded for non-systematic, diversifiable risk. In an efficient market, there’s no extra reward for taking this kind of risk.
Therefore, only the systematic risk is priced and compensated for, while non-systematic risk does not generate any return. It is, therefore, an investor’s interest to diversify the non-systematic risk element within a portfolio.
Question
Which statement best describes systematic risk?
A. Systematic risk can be diversified, and investors are not compensated for this risk.
B. Systematic risk cannot be diversified, and investors are compensated for this risk.
C. Systematic risk can be diversified, and investors are not compensated for this risk.
Solution
The correct answer is B.
You can’t diversify systematic risk because it’s market-related. Investors get rewards for taking systematic risks. However, they don’t get compensated for non-systematic, diversifiable risk, which they should spread across various assets in their portfolios.
Sergio Torrico
2021-07-23
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2021-07-17
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2021-07-16
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2021-06-28
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2021-06-22
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2021-05-10
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2021-03-24
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2021-03-18
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