LOS 44c Question

CFA Level I
#1

“Explain systematic and nonsystematic risk, including why an investor should not expect to receive additional return for bearing nonsystematic risk.”

For some reason this isn’t clicking with me - - it seems like you could expect at least the possibility of additional return for bearing nonsystematic risk. I guess I understand the conclusions but not how we get there.The example in Schweser is a biotech stock:

“The high risk of our biotech stock, however, is primarily from firm-specific factors, so its unsystematic risk is high. Because market factors such as economic growth rates have little to do with the eventual outcome for this stock, systematic risk is a small proportion of the total risk of the stock. Capital market theory says that the equilibrium return on this stock may be less than that of a stock with much less firm-specific risk but more sensitivity to the factors that drive the return of the overall market”. (Corporate Finance, Portfolio Management, and Equity Investments, p. 164)

But the equilibrium return on this stock may be more, too, couldn’t it? Why must the equilibrium return be less?

#2

I read the curriculum, and what I understand of the LOS is diversification doesn’t take away systematic risk, but it takes away unsystematic risk, hence there should be compensation for this portioin of risk that can’t be taken care of by conscious efforts of the manager. So the manager with a portfolio of both kind of risks diversifies, thus reducing his exposure from both systematic and unsystematic risks to just systematic risks alone, and earns the compensation of systematic risk on both. Lol. I hope that made sense.

#3

Exactly.

You cannot diversify away systematic risk, so you should be compensated for accepting it. You can diversify away nonsystematic risk, so you should not be compensated for accepting it.

#4

Why doesn’t the magician have Convexity on his site? I totally have a problen in that area.

#5

Maybe nobody’s ever asked him nicely to write such an article.

#6

Oh great magician, if thou wouldst, bestow upon us, a fruit of your knowledge in the orchard of Convexity. That should work…

#7

Maybe.

wink