Systematic and Unsystematic Components of Return

The distinction between a systematic risk and an unsystematic risk is never really 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. This is true because every enterprise, no matter how tiny, is a part of the economy. It's like the tale of a kingdom that was lost because one horse lost a shoe. This is mostly hairsplitting, however. Some risks are clearly much more general than others. We'll see some evidence on this point in just a moment.

The distinction between the types of risk allows us to break down the surprise portion, U, of the return on the Flyers stock into two parts. Earlier, we had the actual return broken down into its expected and surprise components:

We now recognize that the total surprise component for Flyers, U, has a systematic and an unsystematic component, so:

R = E(R) + Systematic portion + Unsystematic portion [13.5]

Because it is traditional, we will use the Greek letter epsilon, e, to stand for the unsystematic portion. Because systematic risks are often called market risks, we will use the letter m to stand for the systematic part of the surprise. With these symbols, we can rewrite the formula for the total return:

The important thing about the way we have broken down the total surprise, U, is that the unsystematic portion, e, is more or less unique to Flyers. For this reason, it is unrelated to the unsystematic portion of return on most other assets. To see why this is important, we need to return to the subject of portfolio risk.

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