Fundamental Risk

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PJStyles

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I want to see if I got this right. There is no fundamental risk when an investor uses a pair trade of perfect substitutes within the same industry. However, whenever a close substitute for a pair trade does not exist, Fundamental Risk represents FIRM SPECIFIC RISK since no perfect substitute exists.
So to summarize:
- When Perfect substitutes exist, No Fundamental Risk.
- When Close substitues exist, Fundamental Risk represents the portion of firm specific risk that the investor is exposed to because of an imperfect hedge and this risk cannot be hedged.
- When no close substitutes exist, Fundamental Risk represents industry risk since no substitutes exist and since this represents Systematic Risk, it cannot be eliminated via a pair trade in the portfolio.
Someone please chime in… Thanks
PJStyles
 
my view on pair trading is different from yours, but i am not sure if i am right.
i think the pair trading investor is taking on specific risk for a premium but hedging away beta risk, i.e. fundamental risk.
through pair-trading with two perfect substitutes (one long, one short), the beta exposure get cancelled out. the only exposures left are specrisks of the two that the investor feels comfortable to deal.
if substitutes are imperfect, the investor then has to face some unhedged beta risk.
our key difference is if the specific risk is what pair-trading investors are tring to hedge or to take?
 
Actually your explanation is perfect… I knew I had it messed up there somewhere… Essentially:
Perfect Substitutes - No Systematic Risk Due to Perfect Hedge - Only exposed to specific firm risks.
Imperfect Substitutes - Face both Systematic & Unsystematic Risk since beta/market exposure could not be paired off.
I guess where I get confused is when they start discussing risk-averse risk arbitrageurs where they state on page 190:
“First assume a close substitute for a pair trade does not exist. This leaves the arbitrageur in a position where he must be willing to accept the industry risk. Since arbitrageurs are risk averse, they will not be willing to exploit such mispricings by taking large positions. Next, since the fundamental risk is SYSTEMATIC, it cannot be eliminated by adding the pair to the manager’s portfolio.”
Can someone please clarify this paragraph for me… Sounds simple enough but for whatever reason, still don’t have my head wrapped around this above statement.
Thanks
PJStyles
 
make sense. if close/perfect pairs are hard to find, adding more of those imperfect ones into one portfolio would produce diversification effect. the portfolio could end up less and less idiosyncratic risk which are indeed the ture causes of mispricing.
 
Point of clarification. I may be restating what is in the thread but here is how I think about it.
You have “fundamental risk” (pure risk that the security’s instrinsic value is incorrectly estimated) and “noise risk” (risk from noise traders that can lead to persistant mis-pricing). When an arbitrageur enages in a pair trades they eliminate “fundamental risk” but are still exposes to “noise risk”. If an arbitrageur engages in a pair trade with imperfect substitutes, the arbitageur is still exposed to “fundamental risk” and “noise risk” if the arbitraguer engages in a trade with perefct substitutes they are sill exposed to “noise risk”. I think Schewser changes terms a bit and calls “fundamental risk” “industry risk” but they really are the same thing in this context.
Also, PJStlyes, in your posting about you sai a perfect hedge has no systematic risk. I do not think that this is true, there is always systematice risk, only fundamental (or unsystematic risk) is hedged away.
Please let me know if this sounds off.
Also question - the term “specifc risk” was mentionned frequently in this thread. Was that term in CFAI readings? I only saw “specific risk” in the context of stage of Low basis stock in study sesson 5.
 
I had problems with this exact paragraph, until I went over the CFAI reading and reached a conclusion:
Assumed you take a trade Long Ford - Short GM.
you are hedged against any news related to the automotive industry as a whole. However you are still exposed to the fundamental risk of any piece of news coming out related to Ford in particular or GM in particular (risk classified as systematic in this case, even if it relates to a company in particular, because you can’t eliminate this risk by adding the pair to your existing portfolio).
That’s my understanding of the terminology used and why the fundamental risk is defined as systematic in this case.
 
Fundemental risk <==> Specific risk. Am I wrong/right drawing that inference?
 
Good question, I need to reread. In short, I would say yes. I think both are really “unsyematic risk” when it comes down to it. Its just that those bozos at CFAI keep using words that have other connotations in the investment community and wind up confuing people for no reason.
 
You mention that you’re still exposed to fundamental risk because although the industry risk has been eliminated, you’re still exposed to individual firm risk for each of the stocks you’ve taken a position in. However, if you have perfect substitutes, there are still firm specific events that can impact each of the stocks yet there is deemed to be no fundamental risk because both stocks exhibit the same Systematic and Unsystematic Risk.
Okay… Need more clarification on this term :) lol
I completely understand how when the 2 companies/stocks are not perfect substitutes, the investor is subject to fundamental risk because each position short/long doesn’t react exactly in the same manner to micro or macro events. I guess what I want to know is what type of risk is this? Systematic? Unsystematic?
My understanding is that in the case of imperfect substitutes, the investor is faced with both Systematci and Unsystematic risk but I’m hoping someone can clarify exactly how those risks are defined.
For example, is Systematic risk the fact that since the substitutes are imperfect, the investor no longer has a market neutral position and is exposed to the general market ie: Beta. And unsystematic risk being the specific firm risks associated with each?
Clarification on this would be great… Thanks
P.S - Almost get the feeling I’m making this more complicated than it needs to be but I just want to wrap my head around the Systematic/Unsystematic part…. Thanks
mo34 Wrote:
——————————————————-
> I had problems with this exact paragraph, until I
> went over the CFAI reading and reached a
> conclusion:
>
> Assumed you take a trade Long Ford - Short GM.
>
> you are hedged against any news related to the
> automotive industry as a whole. However you are
> still exposed to the fundamental risk of any piece
> of news coming out related to Ford in particular
> or GM in particular (risk classified as systematic
> in this case, even if it relates to a company in
> particular, because you can’t eliminate this risk
> by adding the pair to your existing portfolio).
>
> That’s my understanding of the terminology used
> and why the fundamental risk is defined as
> systematic in this case.
 
Well, to my understanding. I think fundmental risk is the same as specific risk. Since both risk is pointing to the actual company/security in question. ChiTownShane….you are right…they just throw around those words to confused us on purpose.
 
ws Wrote:
——————————————————-
> Fundemental risk <==> Specific risk. Am I
> wrong/right drawing that inference?
i think you are wrong. (if one wants industry/sector/market exposure, he would buy index fund, instead of pair trading)
let’s use regression to explain this,
R(ford) = alpha(ford) + beta(ford) * RP(auto);
R(gm) = alpha(gm) + beta(gm) * RP(auto);
pair trading (long gm, short ford);
R(port) = [alpha(gm) - alpha(ford)] + [beta(gm) - beta(ford)] * RP(auto);
if ford and gm are perfect pair, then they should have same beta exposure, the portfolio ends up with pure alpha difference. investor wants to gain on postive alpha from gm and negative alpha from ford.
what this says?
alpha risk is specific risk (unsystematic risk, idiosyncratic risk). beta risk is fundamental risk (systematic risk, market risk).
one can also use more complicated fama french framework to define pairs. but the idea should be the same.
 
PJStyles Wrote:
——————————————————-
> However, if you have perfect
> substitutes, there are still firm specific events
> that can impact each of the stocks yet there is
> deemed to be no fundamental risk because both
> stocks exhibit the same Systematic and
> Unsystematic Risk.
>
Actually I believe that even if they are perfect substitutes (same beta) you are still exposed to the fundamental risk of each security, since this risk is company specific it should be classified as unsystematic, but since it can not be eliminated by diversification, they chose to classify it as systematic .
So my understanding is even if you have the best pair possible, you are still exposed to fundamental risk and you can’t get rid of it.
 
I think we are making things way too complicated. In the contect of Study Session 3 regarding implementation costs and risks, there is noise risk and fundamental risk. Noise risk is caused by irrational traders.
Anything that is not noise risk in this context is fundamental risk. It is a catch-all. phrase I wouldn’t overthink this one.
mo34 Wrote:
——————————————————-
> I had problems with this exact paragraph, until I
> went over the CFAI reading and reached a
> conclusion:
>
> Assumed you take a trade Long Ford - Short GM.
>
> you are hedged against any news related to the
> automotive industry as a whole. However you are
> still exposed to the fundamental risk of any piece
> of news coming out related to Ford in particular
> or GM in particular (risk classified as systematic
> in this case, even if it relates to a company in
> particular, because you can’t eliminate this risk
> by adding the pair to your existing portfolio).
>
> That’s my understanding of the terminology used
> and why the fundamental risk is defined as
> systematic in this case.
 
Perfect Hedge = Only Noise trader risk
Imperfect = Fundamental & Noise trader risk
 
Mr.Good.Guy Wrote:
——————————————————-
> Perfect Hedge = Only Noise trader risk
> Imperfect = Fundamental & Noise trader risk
having that said…all the noise in my head are gone!!!
 
rand0m Wrote:
——————————————————-
> ws Wrote:
> ————————————————–
> alpha risk is specific risk (unsystematic risk,
> idiosyncratic risk). beta risk is fundamental
> risk (systematic risk, market risk).
This makes perfect sense to me… which is exactly what I was originally thinking… Thanks for breaking it down for me… much appreciated.
Mr. Good Guy,
I like your summary as well and I had that pretty much already ingrained in my head but what I really wanted clarification on is what type of risk is Fundamental Risk and it’s clear that it’s Systematic risk because imperfect substitutes will no longer lead to a market-neutral position where only the alpha is captured ( WS’s comment above).
Thanks for the clarification guys…
PJStyles
 
A friend of mine contacted the authors of ‘A Survey of Behavioral Finance’ to inquire about Fundamental Risk. Here is the response from one of the authors:
====================================================
Subject: RE: How would you define fundamental risk?
Date: Fri, 4 Apr 2008 16:40:09 -0400
From: “Barberis, Nicholas”
To: XXXXXX
XXXXX,
No, fundamental risk is something else. It is the risk of bad news about the stock’s fundamental value, i.e. its true value. An example would simply be bad earnings news, which is bad news about the true underlying value of the stock.
The risk you mention is something else, known as noise-trader risk.
NB
From: XXXXXX
Sent: Thursday, April 03, 2008 11:21 PM
To: Barberis, Nicholas;
Subject: How would you define fundamental risk?
As part of my CFA preparation, I am studying your readings on behavioral finance (A Survey of Behavioral Finance). I will appreciate it, if you can define ‘Fundamental Risk’ for us.
From my own study, I thought that it’s the risk that the security might not return to its fundamental value during the investment time frame of the arbitrageurs. Am I correct?
Regards,
XXXXXX
 
>
>
> No, fundamental risk is something else. It is the
> risk of bad news about the stock’s fundamental
> value, i.e. its true value. An example would
> simply be bad earnings news, which is bad news
> about the true underlying value of the stock.
>
That’s what the CFAI text says. Shweser did not make this point.
 
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