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Total Risk, Diversifiable Risk and Nondiversifiable Risk: A Pedagogic Note

Published online by Cambridge University Press:  06 April 2009

Moshe Ben-Horim  and
Haim Levy
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Extract

The decomposition of a security risk into diversifiable (or unsystematic) and nondiversifiable (or systematic) risks has emerged from the portfolio approach of capital investment and has culminated in the well-known Capital Asset Pricing Model (CAPM), developed by Sharpe [4], Lintner [3] and others. In this framework, the diversifiable risk is the risk that can be “washed out” by diversification and the nondiversifiable risk is the risk which cannot be diversified away. It appears to us that the decomposition of risk into its components is in some cases vague and in most cases imprecise. We define the diversifiable and nondiversifiable risk measures as two complementary components of the standard deviation of a security's rate of return. Furthermore, we require thatthe nondiversifiable risk measure will completely determine its equilibrium market price. We shall see that the definition presented is appealing for all securities and particularly for those with negative Beta. To be more specific, recall that a security's β is given by the slope of the following time series regression:

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 15 , Issue 2 , June 1980 , pp. 289 - 297
Copyright
Copyright © School of Business Administration, University of Washington 1980

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References

REFERENCES

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