Risk Systematic and Unsystematic

The unanticipated part of the return—that portion resulting from surprises—is the true risk of any investment. After all, if we got what we had expected, there would be no risk and no uncertainty.

There are important differences, though, among various sources of risk. Look at our previous list of news stories. Some of these stories are directed specifically at Flyers, and some are more general. Which of the news items are of specific importance to Flyers?

Announcements about interest rates or GNP are clearly important for nearly all companies, whereas the news about Flyers' president, its research, its sales, or the affairs of a rival company are of specific interest to Flyers. We will divide these two types of announcements and the resulting risk, then, into two components: a systematic portion, called systematic risk, and the remainder, which we call specific or unsystematic risk. The following definitions describe the difference:

• A systematic risk is any risk that affects a large number of assets, each to a greater or lesser degree.

• An unsystematic risk is a risk that specifically affects a single asset or a small group of assets.4

Uncertainty about general economic conditions, such as GNP, interest rates, or inflation, is an example of systematic risk. These conditions affect nearly all stocks to some degree.

4In the previous chapter, we briefly mentioned that unsystematic risk is risk that can be diversified away in a large portfolio. This result will also follow from the present analysis.

Ross-Westerfield-Jaffe: I III. Risk I 11. An Alternative View of I I © The McGraw-Hill

Corporate Finance, Sixth Risk and Return: The Companies, 2002

Edition Arbitrage Pricing Theory

288 Part III Risk

An unanticipated or surprise increase in inflation affects wages and the costs of the supplies that companies buy, the value of the assets that companies own, and the prices at which companies sell their products. These forces to which all companies are susceptible are the essence of systematic risk.

In contrast, the announcement of a small oil strike by a company may very well affect that company alone or a few other companies. Certainly, it is unlikely to have an effect on the world oil market. To stress that such information is unsystematic and affects only some specific companies, we sometimes call it an idiosyncratic risk.

The distinction between a systematic risk and an unsystematic risk is never as exact as we make it out to be. Even the most narrow and peculiar bit of news about a company ripples through the economy. It reminds us of the tale of the war that was lost because one horse lost a shoe; even a minor event may have an impact on the world. But this degree of hair-splitting should not trouble us much. To paraphrase a Supreme Court Justice's comment when speaking of pornography, we may not be able to define a systematic risk and an unsystematic risk exactly, but we know them when we see them.

This permits us to break down the risk of Flyers' stock into its two components: the systematic and the unsystematic. As is traditional, we will use the Greek epsilon, e, to represent the unsystematic risk and write

R = R + U = R + m + e where we have used the letter m to stand for the systematic risk. Sometimes systematic risk is referred to as market risk. This emphasizes the fact that m influences all assets in the market to some extent.

The important point about the way we have broken the total risk, U, into its two components, m and e, is that e, because it is specific to the company, is unrelated to the specific risk of most other companies. For example, the unsystematic risk on Flyers' stock, eF, is unrelated to the unsystematic risk of Xerox's stock, ex. The risk that Flyers' stock will go up or down because of a discovery by its research team—or its failure to discover something— probably is unrelated to any of the specific uncertainties that affect Xerox stock.

Using the terms of the previous chapter, this means that the unsystematic risk of Flyers' stock and Xerox's stock are unrelated to each other, or uncorrelated. In the symbols of statistics,

Describe the difference between systematic risk and unsystematic risk. Why is unsystematic risk sometimes referred to as idiosyncratic risk?

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Responses

  • rosalind
    What is financing systematic and unsystematic risk?
    6 years ago
  • faramir proudfoot
    Is it appropriate to divide all risk into Idiosyncratic and Systematic?
    6 years ago
  • rachele
    What is the difference between systematic and unsystematic risk?
    6 years ago

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