Risk Management Framework
Risk management is the process in which the level of risk to be... 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
Excelente para el FRM 2
Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé
AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
diana
2021-07-17
So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts.
The fun light-hearted analogies are also a welcome break to some very dry content.
I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
Kriti Dhawan
2021-07-16
A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them.
Thank you ! Grateful I saw this at the right time for my CFA prep.
nikhil kumar
2021-06-28
Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
Marwan
2021-06-22
Great support throughout the course by the team, did not feel neglected
Benjamin anonymous
2021-05-10
I loved using AnalystPrep for FRM.
QBank is huge, videos are great.
Would recommend to a friend
Daniel Glyn
2021-03-24
I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
michael walshe
2021-03-18
Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.