I was under impression that you can partially diversify fundamental risk as it is a risk that affects company fundamentals and not only market fundamentals. Am i understanding correct? Seems like schweser doesnt agree with me
Yes you can. BUT if you are doing a Pairs Trade you can’t diversify the fundamental risk really.
bigwilly, why not? By joining this pair trade to overall portfolio i can, there is a chance ofcourse that there is a systematic factor mismatches which wont let me diversify
i get confused with these terms – is fundamental risk systematic or unsystematic risk? i thought that the problem with pairs trade arb was that you could eliminate the systematic risk by taking a long and short position in two stocks that are as comparable as possible. unsystematic / specific / fundamental (?) risk, however, cannot be eliminated because the pairs trade falls apart if the risk goes against you (long position goes south or short position goes north). yes?
i believe you Can, that’s the portable alpha strategy… : go long and go short, then take position in the futures or ETF in your country of choice…
3rd & Long Wrote: ------------------------------------------------------- > i believe you Can, that’s the portable alpha > strategy… : go long go short, then short the > futures or ETF in your country of choice… no, portable alpha is adding portfolio with beta 0 to your indexed portfolio - it is a way to ‘port’ active return
yes i think csk is right – having a pairs trade in a portfolio context should eliminate the systematic risk. i thought the point, though, was that arbs aren’t holding portfolios – they are just arbing out inefficiencies. i might have made that up though.
Yeah but you are making a bet with a Pair Trade. For Example if I’m Long McDonald’s and Short Burger King, I’m making a bet that McDonald’s will increase and BK will Decrease. Now if McD’s has Rats in its burgers than the stock is going to sink due to Fundamental Risk and BK might increase b/c everyone go to the Rat free place. So you lose big time on both your Long and Short position. I guess if you look at it with a very well diversified portfolio than this position will be small and the overall contribution will be small so Fundamental risk is low overall. I guess its almost a Catch 22…
in pair trades you are eliminating all risks common to both securities. Now that i think about it, fundamental risk cannot be divirsified away even partially, as then what is the point of this definition? You always add pair trades to your portfolio, you never trade pair trades separately
so fundamental risk = specific risk = unsystematic risk =/= systematic risk yes?
No you dont eliminate all risks common to both as say Food Prices increase, in my example BK will decrease so you’ll gain but McD’s will also Decrease so you’ll lose money, net/net depends on size and % change. But you didnt eliminate that risk with a pairs trade.
ok i think i am anchoring. I will what i originally thought was right and schweser was wrong. Damn it, i need my CFAI books with me!!!
i thought: pairs trade will reduce: systematic risk, market risk, or fundamental risk… and you are still exposed to unsystematic, or ideosyncratic, non market risk… so to get your fundamental risk you could now buy S&P futures or the SPDR for example with your unds from shorting the one stock… is this way off base?
3rd that is not true, you diversify unsystematic risk when you construct your long/short portfolio
If you are Beta Netural (B = 0) then in theory you have no systematic risk…
bigwilly Wrote: ------------------------------------------------------- > No you dont eliminate all risks common to both as > say Food Prices increase, in my example BK will > decrease so you’ll gain but McD’s will also > Decrease so you’ll lose money, net/net depends on > size and % change. But you didnt eliminate that > risk with a pairs trade. bigwilly is right, this is specific or unsystematic risk. schweser says to call this specific risk on the exam, FWIW. the size of the positions should not be a factor since they should be the same size. it’s not much of a hedge if one of the positions is significantly larger. the problem is that there are almost no perfectly comparable securities in the market, so one stock might react to company specific news while the other has a smaller reaction or no reaction at all (more likely the former).
The size of the positions aren’t always the exact size. Some PMs will put more weight behind their convictions, whether it be more to the long or more to the short side.
bigwilly Wrote: ------------------------------------------------------- > The size of the positions aren’t always the exact > size. Some PMs will put more weight behind their > convictions, whether it be more to the long or > more to the short side. that is hedge equity, market neutral tries to have beta of 0
Portable alpha From Wikipedia, the free encyclopedia Portable alpha is an investment management term which refers to the return of an investment manager who has intentionally and completely eliminated his market risk, or beta. The return of such a portfolio will only represent the manager’s skill in selecting investments within the market, and will be independent of the direction or magnitude of the market’s movement. The elimination of market risk can be accomplished through use of futures, swaps, options, or short selling. See Alpha for a definition of alpha. Here, Portable Alpha implies that the extra returns (alpha) can be separated from the changes of the market by hedging the market exposure of the portfolio. The process of Portable Alpha is also sometimes referred to as Alpha Transport
CSK…Hedge Equity or Market Neutral are on the Portfolio as a whole. Not necessarily every individual position. Hedge equity would have a Net Exposure of usually greater than 10-20%, while a Mkt Neutral should have a Net Exp of roughly 0%, but typically can be -10 to +10%, which would be “Dollar Neutral”, you can have a portfolio with Higher Exposures that is Beta Neutral. Both of these are still “Mkt Neutral” strategies. I guess if you want to for the Exam purposes that if you have $100 in MCD you must have $100 in BK then that’s fine…