This is about Practice problem EOC for Reading 13 page 93. Drives me nuts when the authors used by CFAI come up with names for risks. (1) Solution on page book 2 page 93 says “trading risk” is a chronic inefficiency hard to exploit. What on earth is “trading risk”? (2) Same solution seems to suggest economist in the case is correct when he says “fundamental risk is made partially better by shorting a substitute stock” I thought fundamental risk is “specific/idiosynchratic risk” of a stock and can’t be diversified away. Can someone look at this CFAI practice problem?
never heard of trading risk , but in going thru the problem , it looks like it means that a mispricing which is expected to revert to the norm , never does , because of low liquidity and no interest in the stock . This is chronic inefficiency( mispricing) caused by wide bid ask , and no attempt to correct it, so you as the investor/trader are left holding the bag. I would think fundamental risk is a systematic risk ( such as a small cap risk or a sector risk e.g. Energy stock with energy sector characteristic) i.e. there is a fundamental theme to the trade that you are NOT interested in . You do want to exploit the idiosyncratic opportunity of the stock , but remove the fundamental risk component , so you find a partner stock ( same industry but obviously not same idiosyncratic opportunity ) and short it. So you remove the sector theme and look for the stock opportunity
Thanks…some EOC Questions use terms which are not defined in the curriculum… This is one of the examples. 1, “Trading risk” may refer to “trading frictions” in the vignette. No description of trading frictions in the book. Knowing it’s chronic inefficiency is good enough for the exam. 2, “fundamental risk” is a systematic risk as decribed by janakisri. Or, we can get its meaning by “reverse engibeering” the answer. By the way, I almost chose the “anchoring” in Q3 as my answer…