True or false: The unsystematic risk of a share of stock is...

Name: Problem 7, Chapter 24: Fundamentals of Corporate Finance
Uploaded: 2021-09-12T08:09:13-08:00
Duration: 1 min 41 s
Channel: Anitha Mary
Description: True or false: The unsystematic risk of a share of stock is irrelevant in valuing the stock because it can be diversified away; therefore, it is also irrelevant for valuing a call option on the stock. Explain.

True or false: The unsystematic risk of a share of stock is irrelevant in valuing the stock because it can be diversified away; therefore, it is also irrelevant for valuing a call option on the stock. Explain.

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Key Concepts

Diversification

Diversification is the strategy of spreading investments across various assets to reduce exposure to any single asset's specific risk. By holding a well-diversified portfolio, the impact of any one asset's unsystematic risk is minimized, leaving primarily the systematic risk that affects the overall market.

Systematic vs Unsystematic Risk

Unsystematic risk refers to risks that are unique to a particular company or industry, such as management decisions or product recalls, and can be eliminated through diversification. In contrast, systematic risk affects all investments across the market, like changes in interest rates or economic downturns, and cannot be diversified away, which makes it the key component considered in asset valuation.

Risk-Neutral Valuation in Option Pricing

Risk-neutral valuation is a framework used in pricing derivatives, such as call options, where the focus is solely on systematic risk. In this model, investors are assumed to be indifferent to risk, allowing the pricing to be based on the expected payoff under a risk-neutral probability measure. Since unsystematic risk is diversifiable and does not affect the overall market risk, it is not factored into these pricing models, making it irrelevant for valuing call options.

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