"residual risk"(low-basis stock)

CFA Level III
#1

low-basis stock (On Page 288, Book 1 of Schweser) about residual risk; Schweser says, if held in a well-diversified port, the holder is left with only the security’s market risk & “residual risk”, and residual risk is broken down into counterparty risk & regulatory risk. in the context of portfolio theory,i know, total risk is comprised of specific risk & market risk, BUT “residual risk” is not relevant to port theory?? specific risk is relevant to port theory but “residual risk” is not… <

#2

That’s a good question. I would say that no, residual risk is not relevant to MPT. A good chunk of residual risk is regulatory, which in the context of low-basis stock reading is the risk that one’s tax avoidance strategies may not work, i.e. taxing authorities may say, “nice try, very creative, now pay your cap gains tax” One of the markowitz assumptions is no taxes and no transaction costs. I think it is safe to say that no taxes removes regulatory risk from consideration. Does no transaction costs assumption remove counterparty risk? I think you could make that argument.

#3

I think the “residual risk” shall be one risk of the “specific risk”. right ?

#4

AMC Wrote: ------------------------------------------------------- > I think the “residual risk” shall be one risk of > the “specific risk”. right ? Specific risk has to do with the business operations of the company itself. The residual risk has to do with the strategy used to avoid taxes with the low basis stock. I would not put the residual risk with specific risk as it has nothing to do with the company itself.

#5

Thanks. Learned!