What percentage of Portfolio A's total risk is unsystematic risk if its standard deviation is 12%, and the market's standard deviation is 16% with a correlation of 0.5?

Prepare for the Kaplan Certified Financial Planner (CFP) Test. Study with flashcards and multiple choice questions, each question has hints and explanations. Get ready for your exam!

To determine the percentage of Portfolio A's total risk that is unsystematic risk, we need to first understand the components of total risk in the context of portfolio management. Total risk is comprised of systematic risk and unsystematic risk.

Systematic risk, also known as market risk, is the portion of total risk that is attributable to macroeconomic factors affecting the entire market, and it cannot be diversified away. Unsystematic risk, on the other hand, is specific to a particular asset or portfolio and can be mitigated through diversification.

In this scenario, we use the formula for the systematic risk of a portfolio, which is calculated as follows:

1. Calculate the Beta (β) of Portfolio A using the correlation with the market and the ratio of the standard deviations. Beta reflects how much the portfolio’s returns move in relation to market returns.

The formula for Beta is:

[

\beta = \text{Correlation} \times \left(\frac{\text{Standard Deviation of Portfolio A}}{\text{Standard Deviation of Market}}\right)

]

Plugging the given values into the formula:

[

\beta = 0.5 \times \left(\frac{12