FIN2004 JAN17 Tutorial 4 Risk and Return II.pdf - Tutorial 4 Risk and Return II Conducted by Mr Chong Lock Kuah CFA Systematic and Unsystematic Risk

FIN2004 JAN17 Tutorial 4 Risk and Return II.pdf - Tutorial...

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Tutorial 4 : Risk and Return II Conducted by : Mr Chong Lock Kuah, CFA
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Systematic and Unsystematic Risk When you diversify across assets that are not perfectly correlated, the portfolio’s risk is less than the weighted sum of the risks of the individual securities in the portfolio. The risk that can be diversified away during the portfolio construction process is called the asset’s unsystematic risk (also called unique, diversifiable, or firm-specific risk). Since the market portfolio contains all risk assets, it must represent the ultimate in diversification. All the risk that can be diversified away must be gone. The risk that is left cannot be diversified away, since there is nothing left to add to the portfolio. This risk that remains is called the systematic risk (also called nondiversifiable risk or market risk).
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Cont d The concept of systematic risk applies to individual securities as well as to portfolios. This risk is caused by general factors such as changes in inflation rates, interest rates, and market sentiments that affect all investment types albeit by varying degrees. Number of securities in the portfolio 30 Market Risk, mkt Systematic Risk Unsystematic Risk Total Risk = Unsystematic + Systematic Risk Risk
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Cont d Academic studies have shown that as you increase the number of stocks in a portfolio, the portfolio’s risk falls toward the level of market risk. One study showed that it only took about 12 to 18 stocks in a portfolio to achieve 90 percent of the maximum diversification possible. Another study indicated it took 30 securities. Whatever the number, it is significantly less than all the securities.
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Systematic Risk Is Relevant in Portfolios In the previous section on the Markowitz portfolio model, it was noted that the relevant risk to consider when adding a security to large portfolio is its average covariance with all other assets in the portfolio . Combining this concept with the idea that the only relevant portfolio is the market portfolio, results in the conclusion that the relevant risk measure for an individual risky asset is its covariance with the market portfolio , also known as its systematic risk. Since unsystematic risk can be diversified away, and therefore, unsystematic risk is not relevant to investors. The only relevant risk is systematic risk. Therefore, investors should be compensated for accepting risk that cannot be diversified away i.e. the systematic risk and not the unsystematic risk.
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Capital Asset Pricing Model (CAPM) The CAPM states that in perfect markets, all unsystematic risk can be eliminated through diversification by forming portfolios of two or more securities. A perfect market is one where there is no trading friction, that is, there are no transaction costs, information is costless, and all assets are divisible.
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