Financial Risk Manager Part 1
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Equity price risk is the type of market risk that refers to the variability in the prices of equity or stocks. Equity price risk is further subdivided into specific risk and systematic risk. Which of the following is most likely a type of specific risk?
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A
The risk of changes in the consumer price index (CPI).
B
The risk of change in the aggregate demand of a specific sector.
C
The risk of strategic weaknesses in a business.
D
The risk of changes in tax rates.
Explanation:
Explanation
The correct answer is C - The risk of strategic weaknesses in a business is a type of specific risk.
Understanding Specific Risk vs Systematic Risk
Specific Risk (Unsystematic Risk):
- Also known as idiosyncratic risk or diversifiable risk
- Refers to risks that are unique to individual companies or stocks
- Can be reduced or eliminated through portfolio diversification
- Examples: management decisions, operational issues, company-specific events
Systematic Risk (Market Risk):
- Affects the entire market or economy
- Cannot be eliminated through diversification
- Examples: inflation, interest rate changes, tax policy changes
Analysis of Each Option
Option A (Incorrect): Changes in CPI represent inflation risk, which is a systematic risk affecting all companies in the economy.
Option B (Incorrect): Changes in aggregate demand for a specific sector affect all companies within that sector, making it a systematic risk for that sector.
Option C (Correct): Strategic weaknesses in a business (such as poor management decisions, operational inefficiencies, or failed investments) are company-specific and can be diversified away, making this a specific risk.
Option D (Incorrect): Changes in tax rates affect all businesses operating within an economy and cannot be diversified away, making this a systematic risk.
Key Takeaway
Specific risks are unique to individual companies and can be managed through diversification, while systematic risks affect the entire market and cannot be eliminated through diversification.
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