The Systematic Risk Principle

Thus far, we've seen that the total risk associated with an asset can be decomposed into two components: systematic and unsystematic risk. We have also seen that unsystematic risk can be essentially eliminated by diversification. The systematic risk present in an asset, on the other hand, cannot be eliminated by diversification.

Based on our study of capital market history, we know that there is a reward, on average, for bearing risk. However, we now need to be more precise about what we mean by risk. The systematic risk principle states that the reward for bearing risk depends only on the systematic risk of an investment. The underlying rationale for this principle is straightforward: because unsystematic risk can be eliminated at virtually no cost (by diversifying), there is no reward for bearing it. Put another way, the market does not reward risks that are borne unnecessarily.

The systematic risk principle has a remarkable and very important implication:

The expected return on an asset depends only on that asset's systematic risk.

There is an obvious corollary to this principle: no matter how much total risk an asset has, only the systematic portion is relevant in determining the expected return (and the risk premium) on that asset.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

V. Risk and Return

13. Return, Risk, and the Security Market Line

© The McGraw-Hill Companies, 2002

CHAPTER 13 Return, Risk, and the Security Market Line

Beta Coefficient (p;)

American Electric Power

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