Corporate Finance Quiz: Systematic Vs Unsystematic Risk
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Systematic Vs Unsystematic RiskQuestion 1 of 20

A pharmaceutical company's stock has a beta of 0.9. During a period when the market rose 8%, the stock rose 12%. The company announced positive results from a Phase III clinical trial during this period. If an investor wants to estimate what portion of the stock's return was due to systematic versus unsystematic factors, which calculation is most appropriate?

Systematic return: 7.2%, Unsystematic return: 4.8%, since beta-adjusted market return plus company-specific news explains the total return
Systematic return: 8%, Unsystematic return: 4%, since market return plus excess return above market explains the total return
Systematic return: 12%, Unsystematic return: 0%, since the clinical trial news was already incorporated in the stock's beta coefficient
Systematic return: 9.6%, Unsystematic return: 2.4%, since the stock's sensitivity to market movements exceeds the actual systematic component
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Corporate Finance Quiz

Corporate Finance Quiz: Systematic Vs Unsystematic Risk

Practice Systematic Vs Unsystematic Risk in Corporate Finance with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

What this quiz covers

This quiz focuses on Systematic Vs Unsystematic Risk, giving you a quick way to practice the rules, question types, and explanations that matter most for Corporate Finance.

How to use this quiz

Try each quiz question before looking at the correct answer. Use the explanations to review missed ideas, then come back to similar questions until the pattern feels familiar.

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Question 1

A pharmaceutical company's stock has a beta of 0.9. During a period when the market rose 8%, the stock rose 12%. The company announced positive results from a Phase III clinical trial during this period. If an investor wants to estimate what portion of the stock's return was due to systematic versus unsystematic factors, which calculation is most appropriate?

  1. Systematic return: 7.2%, Unsystematic return: 4.8%, since beta-adjusted market return plus company-specific news explains the total return (correct answer)
  2. Systematic return: 8%, Unsystematic return: 4%, since market return plus excess return above market explains the total return
  3. Systematic return: 12%, Unsystematic return: 0%, since the clinical trial news was already incorporated in the stock's beta coefficient
  4. Systematic return: 9.6%, Unsystematic return: 2.4%, since the stock's sensitivity to market movements exceeds the actual systematic component
Explanation: Systematic return = Beta × Market return = 0.9 × 8% = 7.2%. The unsystematic return is the portion not explained by market movements: 12% - 7.2% = 4.8%. This represents the impact of company-specific news (clinical trial results). Choice B incorrectly uses the full market return instead of the beta-adjusted market return for systematic risk. Choice C incorrectly assumes all return is systematic and that beta incorporates future news. Choice D contains a calculation error and misunderstands that beta measures sensitivity, not excess systematic exposure.

Question 2

A biotech startup's stock has exhibited the following pattern: it moves independently of general market trends but shows extreme volatility around FDA approval announcements, clinical trial results, and patent decisions. The stock's correlation with the market index is 0.15. Which statement best characterizes this stock's risk profile?

  1. The stock exhibits high systematic risk due to its sensitivity to regulatory announcements, which affect the entire pharmaceutical sector
  2. The stock exhibits equal amounts of systematic and unsystematic risk, with the low correlation indicating balanced risk exposure
  3. The stock exhibits primarily unsystematic risk, with low systematic risk as evidenced by weak correlation with market movements (correct answer)
  4. The stock exhibits high systematic risk despite low market correlation because biotech regulatory risks cannot be diversified away by investors
Explanation: When you encounter questions about stock risk profiles, focus on distinguishing between systematic risk (market-wide, undiversifiable) and unsystematic risk (company-specific, diversifiable). The key indicator is correlation with market movements. This biotech stock shows a correlation of only 0.15 with the market index, indicating very weak relationship to overall market movements. The extreme volatility occurs around company-specific events like FDA approvals, clinical trials, and patent decisions—these are idiosyncratic factors that don't affect the broader market. This pattern points to predominantly unsystematic risk that could be diversified away in a well-balanced portfolio. Answer C correctly identifies this as primarily unsystematic risk with low systematic risk, supported by the weak market correlation. Answer A incorrectly categorizes regulatory announcements as systematic risk. While FDA decisions affect the pharmaceutical sector, they don't move the entire market—they're industry or company-specific events that represent unsystematic risk. Answer B misinterprets the low correlation as indicating "balanced" risk exposure. Low correlation actually suggests minimal systematic risk exposure, not equal amounts of both risk types. Answer D contains a fundamental misconception about diversification. The fact that biotech regulatory risks affect multiple biotech companies doesn't make them systematic—they can still be diversified away by including non-biotech stocks in a portfolio. True systematic risk affects virtually all securities. Remember: correlation with the market index is your best clue for systematic risk. Low correlation (like 0.15) typically signals predominant unsystematic risk, regardless of how volatile the individual stock appears.

Question 3

An investor's portfolio consists of 15 stocks from different industries. The portfolio's beta is 1.1. The investor decides to add a 16th stock, which has a beta of 0.7 and is in an industry not yet represented in the portfolio. What is the most likely combined effect on the portfolio's risk?

  1. Both systematic and unsystematic risk will decrease. (correct answer)
  2. Systematic risk will decrease, while unsystematic risk will increase.
  3. Systematic risk will increase, while unsystematic risk will decrease.
  4. Both systematic and unsystematic risk will increase.
Explanation: Adding a stock with a beta (0.7) that is lower than the portfolio's current beta (1.1) will lower the weighted-average beta of the new portfolio. This represents a decrease in systematic risk. Adding another stock to a 15-stock portfolio, especially from a new industry, will also increase its diversification, which reduces the portfolio's remaining unsystematic risk. Therefore, both risk components are likely to decrease.

Question 4

A pharmaceutical company, whose stock has a beta of 0.9, announces a major, unexpected breakthrough in a clinical trial for a new Alzheimer's drug. The success of this drug is not dependent on general economic conditions. The company's stock price increases by 30% on a day when the overall market is flat.

From the perspective of a well-diversified investor, how does this event and the subsequent price change primarily relate to the company's risk profile?

  1. It represents a realization of unsystematic risk and does not, in itself, imply a change in the stock's beta. (correct answer)
  2. It increases the stock's systematic risk because the company's value has substantially increased.
  3. It decreases the stock's unsystematic risk because a major uncertainty has been favorably resolved.
  4. It demonstrates that the stock's beta was an inaccurate measure of its true systematic risk.
Explanation: The drug breakthrough is a firm-specific event. Its impact on the stock price, independent of the market's movement, is a manifestation of unsystematic (or diversifiable) risk. A diversified investor is exposed to such events for each stock they hold. This single event does not necessarily change the stock's fundamental sensitivity to market-wide economic factors, which is what beta measures. While the resolution of uncertainty is positive, the potential for such large, firm-specific swings is the definition of unsystematic risk.

Question 5

A regression of a stock's monthly returns against the market's monthly returns over five years produces an R-squared value of 0.30. Which of the following is the most accurate interpretation of this result?

  1. 30% of the stock's expected return is due to its systematic risk.
  2. The stock's beta is 0.30, indicating it is less risky than the market.
  3. 70% of the stock's total risk is diversifiable. (correct answer)
  4. The stock has a 30% correlation with the market portfolio.
Explanation: In a regression of asset returns on market returns, R-squared measures the proportion of the asset's total variance (total risk) that is explained by the market's variance (systematic risk). If R-squared is 0.30, it means 30% of the stock's total risk is systematic. The remaining portion, 1 - R-squared = 1 - 0.30 = 0.70, or 70%, represents the proportion of total risk that is unsystematic, or diversifiable.

Question 6

A mature, stable electric utility company (Beta = 0.6) decides to acquire a high-growth, speculative software startup. The success of the startup's main product is highly uncertain and depends on technological innovation and competitive dynamics within the software industry, not the overall economy.

Assuming the acquisition is a significant portion of the utility's value, what is the most likely impact on the combined firm's risk profile?

  1. The firm's beta will increase significantly, while its unsystematic risk will decrease.
  2. The firm's total risk (standard deviation) will increase, while its beta may only change slightly. (correct answer)
  3. Both the firm's systematic and unsystematic risk will decrease due to diversification benefits.
  4. The firm's beta will remain unchanged, but its expected return will decrease to reflect the higher risk.
Explanation: The software startup's risks are described as being independent of the overall economy, which means they are primarily unsystematic. Adding this high-risk, high-volatility business will substantially increase the combined firm's overall variance of returns (total risk). However, because the new risks are not correlated with the market, they will not add much systematic risk. Therefore, the firm's beta, a measure of systematic risk, will likely not increase significantly. It will be a weighted average of the utility's low beta and the startup's beta (which may be low if its returns are truly uncorrelated with the market), so the combined beta could change slightly but not nearly as much as the total risk.

Question 7

Stock A has a beta of 1.4 and a total risk (standard deviation) of 35%. Stock B has a beta of 1.4 and a total risk of 45%. Assuming both stocks are priced in equilibrium according to the Capital Asset Pricing Model (CAPM), what can be concluded about their expected returns?

  1. Stock B will have a higher expected return to compensate for its higher total risk.
  2. Stock A and Stock B will have the same expected return. (correct answer)
  3. Stock A will have a higher expected return because its risk is more systematic in nature.
  4. The stock with the lower level of unsystematic risk will have the higher expected return.
Explanation: The CAPM posits that the expected return on an asset is determined only by its systematic risk, as measured by beta. Unsystematic risk, which can be eliminated through diversification, does not command a risk premium in the market. Since both Stock A and Stock B have the same beta (1.4), they have the same level of systematic risk. Therefore, according to CAPM, they must have the same expected return, regardless of the difference in their total risk (standard deviation). The higher total risk of Stock B comes from a larger component of unsystematic risk, for which investors are not compensated.

Question 8

A manufacturing company's stock has a total risk, measured by standard deviation, of 40%. The standard deviation of the market portfolio is 20%, and the stock's beta is 1.5. What is the approximate standard deviation of the stock's firm-specific (unsystematic) returns?

  1. 10.0%
  2. 20.0%
  3. 26.5% (correct answer)
  4. 34.6%
Explanation: Total variance of a stock is the sum of its systematic variance and unsystematic variance: σTotal2=β2σM2+σUnsystematic2\sigma_{Total}^2 = \beta^2 \sigma_M^2 + \sigma_{Unsystematic}^2. We are given σTotal=0.40\sigma_{Total} = 0.40, σM=0.20\sigma_M = 0.20, and β=1.5\beta = 1.5. First, calculate the systematic variance: β2σM2=(1.5)2×(0.20)2=2.25×0.04=0.09\beta^2 \sigma_M^2 = (1.5)^2 \times (0.20)^2 = 2.25 \times 0.04 = 0.09. Next, use the total variance (0.402=0.160.40^2 = 0.16) to find the unsystematic variance: 0.16=0.09+σUnsystematic20.16 = 0.09 + \sigma_{Unsystematic}^2. This gives σUnsystematic2=0.16−0.09=0.07\sigma_{Unsystematic}^2 = 0.16 - 0.09 = 0.07. Finally, take the square root to find the unsystematic standard deviation: σUnsystematic=0.07≈0.2645\sigma_{Unsystematic} = \sqrt{0.07} \approx 0.2645, or 26.5%.

Question 9

An investor holds a market-cap-weighted index fund that tracks the entire stock market. A second investor holds a portfolio of 30 stocks concentrated in a single, non-cyclical industry. By coincidence, both portfolios exhibit the exact same total risk (standard deviation) over the last five years. Which of the following statements must be true?

  1. The 30-stock portfolio has a higher beta than the index fund.
  2. The unsystematic risk of the 30-stock portfolio is zero.
  3. Both portfolios must have the same beta.
  4. The 30-stock portfolio has a lower beta than the index fund. (correct answer)
Explanation: When you encounter questions comparing portfolios with equal total risk but different diversification levels, focus on the relationship between systematic risk (beta) and unsystematic risk components. Both portfolios have identical total risk, but they achieve this through very different risk compositions. The market-cap-weighted index fund is highly diversified across all sectors, so virtually all its risk comes from systematic (market) risk. The 30-stock concentrated portfolio, while somewhat diversified within its industry, carries significant unsystematic risk due to industry concentration. Since total risk equals systematic risk plus unsystematic risk, and both portfolios have the same total risk, the concentrated portfolio must have lower systematic risk (beta) to compensate for its higher unsystematic risk. This makes answer D correct. Answer A is wrong because higher concentration means the portfolio needs lower, not higher, systematic risk to achieve the same total risk as the diversified index. Answer B incorrectly assumes the 30-stock portfolio has eliminated unsystematic risk—while 30 stocks provide some diversification, concentration in one industry leaves substantial unsystematic risk. Answer C fails because equal total risk doesn't mean equal systematic risk when unsystematic risk levels differ significantly between portfolios. Remember this key principle: when comparing portfolios with equal total risk, the less diversified portfolio will typically have lower beta because it carries more unsystematic risk. Total risk is the sum of both components, so one must be lower when the other is higher.

Question 10

A researcher is conducting an event study to measure the stock market's reaction to merger announcements. The researcher calculates abnormal returns by taking the actual stock return on the announcement day and subtracting the expected return predicted by the CAPM (based on the market's return that day and the stock's beta). This abnormal return is a proxy for the financial impact of:

  1. new information related to the stock's systematic risk.
  2. the total risk of the stock on the announcement day.
  3. a change in the stock's beta caused by the merger announcement.
  4. the materialization of unsystematic, firm-specific risk. (correct answer)
Explanation: Event studies are designed to isolate the market's reaction to specific company news by separating expected returns from unexpected price movements. When you calculate abnormal returns using CAPM, you're measuring how much the stock moved beyond what the market model predicted based on systematic risk factors. The correct answer is D because abnormal returns capture the impact of firm-specific, unexpected information. When a merger is announced, this represents new, company-specific news that wasn't previously reflected in the stock price. Since CAMP already accounts for systematic risk through beta and market returns, any remaining abnormal return must be due to unsystematic (firm-specific) risk materializing as new information hits the market. Here's why the other options are incorrect: Option A is wrong because CAPM already controls for systematic risk through the stock's beta and market return - the abnormal return is what's left after removing systematic risk effects. Option B misses the point because abnormal returns specifically isolate the unexpected component, not total risk, which would include both systematic and unsystematic elements that were already anticipated. Option C incorrectly suggests the abnormal return measures a change in beta itself, when actually CAPM uses the stock's existing beta as a given parameter to predict expected returns. Remember this key distinction for event studies: normal returns reflect systematic risk factors the market already knew about, while abnormal returns capture the surprise impact of new, firm-specific information. This is what makes event studies powerful tools for measuring how quickly markets incorporate company-specific news.

Question 11

To estimate the beta for a private company, an analyst first identifies several publicly traded comparable firms. The analyst then calculates the equity beta for each of these firms and 'unlevers' them using their respective capital structures and tax rates. The primary purpose of this unlevering process is to:

  1. remove the effects of unsystematic risk from each comparable firm's beta.
  2. isolate the systematic business risk of the assets, independent of financial leverage. (correct answer)
  3. calculate the total risk of the private company's assets.
  4. adjust for differences in size and industry focus among the comparable firms.
Explanation: A company's equity beta reflects two sources of systematic risk: the business risk of its underlying assets and the financial risk from its use of debt. The process of unlevering the beta (calculating the asset beta) removes the effect of financial risk (leverage). This isolates the pure systematic business risk inherent in the company's operations. This unlevered (asset) beta can then be 're-levered' based on the private company's own target capital structure to arrive at an appropriate equity beta.

Question 12

An investor adds a new stock to a pre-existing, well-diversified 50-stock portfolio. The new stock has a very high standard deviation of returns but a beta of 1.0. Which of the following is the most likely impact on the investor's portfolio?

  1. A significant increase in the portfolio's total risk due to the new stock's high standard deviation.
  2. A decrease in the portfolio's total risk due to the benefits of further diversification.
  3. The portfolio's beta will remain unchanged, and its total risk will only increase negligibly. (correct answer)
  4. The portfolio's unsystematic risk will increase, and its systematic risk will remain unchanged.
Explanation: Since the existing portfolio is already well-diversified (50 stocks), its unsystematic risk is already minimal. Adding a 51st stock will have a negligible effect on further reducing it. The new stock's high standard deviation is mostly due to its high unsystematic risk, but in a well-diversified portfolio, this unsystematic risk is effectively diversified away. The stock's contribution to the portfolio's risk is determined by its systematic risk (beta). Since the new stock's beta (1.0) is likely close to the beta of a broadly diversified portfolio, the portfolio's overall beta will remain largely unchanged. Thus, neither the systematic nor the remaining unsystematic risk of the portfolio will change much, leading to a negligible change in total risk.

Question 13

A portfolio manager is seeking to construct a new fund with the lowest possible level of systematic risk, without using short-selling or derivatives. The investment universe consists of publicly traded equities. Which of the following strategies is most appropriate?

  1. Select a large number of stocks randomly from the S&P 500 to ensure maximum diversification.
  2. Select stocks from defensive, non-cyclical sectors like utilities and consumer staples. (correct answer)
  3. Select stocks that have historically exhibited the lowest correlation with each other.
  4. Select stocks that have the lowest total standard deviation of returns.
Explanation: Systematic risk is measured by beta, which reflects a stock's sensitivity to overall market movements. To minimize systematic risk, the manager should select stocks with low betas. Stocks in defensive, non-cyclical sectors (like utilities and consumer staples) tend to have low betas because their business performance is less dependent on the overall state of the economy. While diversification (A and C) is crucial for eliminating unsystematic risk, it does not minimize systematic risk; the portfolio's beta will simply approach the average beta of the selected stocks. Choosing stocks with low total standard deviation (D) is not ideal, as a stock could have low total risk but a relatively high beta if its unsystematic risk is very low.

Question 14

An analyst is evaluating two different portfolios. Portfolio X is concentrated, holding five stocks in the semiconductor industry. Portfolio Y is a broad market index fund. Both portfolios currently have an estimated beta of 1.2. Which of the following statements is most likely correct?

  1. Portfolio X has a lower total risk than Portfolio Y because it is more focused.
  2. According to CAPM, Portfolio X should have a higher expected return than Portfolio Y to compensate for its higher unsystematic risk.
  3. Portfolio Y likely has a lower standard deviation of returns than Portfolio X. (correct answer)
  4. The systematic risk of Portfolio X is higher than the systematic risk of Portfolio Y.
Explanation: Since both portfolios have the same beta (1.2), they have the same level of systematic risk. However, Portfolio Y, as a broad market index, is well-diversified and has very little unsystematic risk. Portfolio X, being concentrated in a single industry, carries a significant amount of unsystematic risk. Total risk (measured by standard deviation) is the sum of systematic and unsystematic risk. Because Portfolio X has the same systematic risk as Y but more unsystematic risk, its total risk (standard deviation) will be higher. Therefore, Portfolio Y will have a lower standard deviation.

Question 15

From the perspective of a domestic U.S. investor holding only U.S. stocks, a sudden political crisis in a small, foreign country is typically considered unsystematic risk. From the perspective of an investor in that small foreign country, the same political crisis is best described as:

  1. unsystematic risk, because it is specific to their country and can be diversified by investing globally.
  2. systematic risk, because it affects nearly all companies and investments within that country. (correct answer)
  3. neither systematic nor unsystematic risk, as political events fall outside standard financial risk models.
  4. a diversifiable risk that has no bearing on expected returns for domestic investors.
Explanation: Systematic risk is risk that cannot be diversified away within a given market. For an investor whose entire portfolio is confined to a single country, a major political or economic crisis in that country affects all assets and cannot be avoided by diversifying across domestic industries. Therefore, it acts as systematic risk for that local investor. For a global investor, however, this country-specific risk can be diversified away by investing in other countries, making it appear as unsystematic risk from their broader perspective.

Question 16

A large, global shipping company is heavily affected when a key international strait is closed due to geopolitical conflict, causing shipping routes to be redrawn at a much higher cost. In the same month, central banks around the world raise interest rates unexpectedly to combat inflation. How should a financial analyst primarily categorize these two risk factors for the shipping company?

  1. The strait closure is unsystematic risk, while the interest rate hike is systematic risk. (correct answer)
  2. Both events are sources of systematic risk because they are global in nature.
  3. The strait closure is systematic risk, while the interest rate hike is unsystematic risk.
  4. Both events are sources of unsystematic risk because their impact is most severe on the shipping industry.
Explanation: The interest rate hike is a macroeconomic event that affects the valuation and operating conditions of nearly all companies in the global economy; it is a clear example of systematic risk. The closure of a specific shipping strait, while a major event, disproportionately affects companies reliant on shipping and logistics. While it has broader economic consequences, its direct and most severe impact is concentrated, making it a source of unsystematic risk for the shipping firm relative to the market as a whole. An investor can diversify away the risk of a specific shipping lane closure but cannot diversify away the risk of a global interest rate hike.

Question 17

An analyst compares two equity portfolios. Portfolio A is a well-diversified portfolio of 100 stocks from various economic sectors, with a beta of 1.0. Portfolio B consists of 10 stocks, all from the biotechnology industry, and also has a beta of 1.0. Which of the following statements most accurately compares the risk of these two portfolios?

  1. Both portfolios have the same total risk because their systematic risk, as measured by beta, is identical.
  2. Portfolio A has a higher total risk than Portfolio B because it contains more securities.
  3. Portfolio B has a higher total risk than Portfolio A due to a higher level of unsystematic risk. (correct answer)
  4. Portfolio A has a higher level of systematic risk, while Portfolio B has a higher level of unsystematic risk.
Explanation: Total risk is the sum of systematic risk and unsystematic risk. Both portfolios have the same systematic risk because their betas are equal to 1.0. However, Portfolio B is concentrated in a single industry (biotechnology) and is therefore poorly diversified compared to Portfolio A. This concentration means Portfolio B retains a significant amount of firm-specific and industry-specific (i.e., unsystematic) risk. Portfolio A, being well-diversified, has eliminated most of its unsystematic risk. Therefore, Portfolio B will have a higher total risk (as measured by standard deviation) than Portfolio A.

Question 18

Stock X has a beta of 1.3. Stock Y has a beta of 0.9. An analyst observes that the correlation of Stock X's returns with the market is lower than the correlation of Stock Y's returns with the market. Which of the following statements provides the best explanation for this observation?

  1. This scenario is impossible, as a higher beta must always be associated with a higher correlation to the market.
  2. Stock Y must have a higher degree of unsystematic risk than Stock X.
  3. Stock X must have a significantly higher standard deviation of returns than Stock Y. (correct answer)
  4. The market risk premium must be unusually low during the measurement period.
Explanation: The formula for beta is βi=ρi,mσiσm\beta_i = \rho_{i,m} \frac{\sigma_i}{\sigma_m}, where ρi,m\rho_{i,m} is the correlation of the stock with the market, σi\sigma_i is the stock's standard deviation, and σm\sigma_m is the market's standard deviation. If Stock X has a lower correlation (ρX,m\rho_{X,m}) than Stock Y (ρY,m\rho_{Y,m}) but a higher beta, it must be compensated for by a much larger ratio of σX/σm\sigma_X / \sigma_m. This means Stock X's individual volatility (standard deviation) must be significantly higher than Stock Y's.

Question 19

A conglomerate corporation is evaluating a new, large-scale project. The project's cash flows are expected to be highly correlated with GDP growth, rising significantly during economic expansions and falling sharply during recessions.

When determining the appropriate risk-adjusted discount rate for this project using the CAPM framework, which risk component is the most critical consideration?

  1. The project's potential for operational failure due to management error.
  2. The standard deviation of the project's expected cash flows.
  3. The high correlation of the project's cash flows with the business cycle. (correct answer)
  4. The risk that the project's technology could become obsolete.
Explanation: The CAPM framework specifies that the appropriate discount rate depends on the project's systematic risk. Systematic risk is the risk that is correlated with the overall market or economy. The statement that the project's cash flows are highly correlated with GDP growth and the business cycle directly indicates that the project has a high degree of systematic risk. This high systematic risk will translate into a high asset beta, which in turn leads to a higher required rate of return (discount rate). The other options—operational failure and technological obsolescence—are examples of unsystematic risk, which can be diversified away within the corporation and are not priced by the CAPM.

Question 20

A quantitative analyst calculates that Stock A has generated excess returns with a tracking error of 15% relative to its benchmark, while Stock B has generated similar excess returns with a tracking error of 5% relative to the same benchmark. Both stocks have identical betas of 1.0. What can be inferred about the risk characteristics of these two stocks?

  1. Stock A has higher systematic risk than Stock B, explaining the higher tracking error despite identical betas
  2. Stock B has higher systematic risk than Stock A, with the lower tracking error indicating better systematic risk management
  3. Both stocks have identical risk profiles since they have the same beta, and the tracking error differences reflect measurement noise
  4. Stock A has higher unsystematic risk than Stock B, as evidenced by the greater deviation from benchmark performance (correct answer)
Explanation: When you encounter questions about tracking error and beta, you're dealing with the fundamental distinction between systematic and unsystematic risk. Beta measures systematic risk (market-related risk that affects all securities), while tracking error captures total deviation from a benchmark, including both systematic and unsystematic components. Since both stocks have identical betas of 1.0, they have the same systematic risk exposure to market movements. However, Stock A's tracking error of 15% versus Stock B's 5% reveals a significant difference in their total risk profiles. Tracking error measures how much a security's returns deviate from its benchmark, encompassing both systematic and unsystematic risk factors. With systematic risk held constant (same beta), the higher tracking error must stem from greater unsystematic risk—company-specific factors like management decisions, industry events, or operational issues that cause Stock A to diverge more dramatically from benchmark performance. Answer choice A incorrectly suggests Stock A has higher systematic risk, but identical betas indicate identical systematic risk. Choice B makes the same error in reverse, misattributing the tracking error difference to systematic risk management rather than unsystematic factors. Choice C dismisses the tracking error difference as measurement noise, ignoring the meaningful information about unsystematic risk that tracking error provides when systematic risk is controlled. Remember this pattern: when securities have identical betas but different tracking errors, the difference reflects unsystematic risk. Beta isolates systematic risk, so any additional deviation captured by tracking error must be company-specific, diversifiable risk.