Question

diversifiable risks. What is the relationship between these two types of risk

Answer 1

Diversifiable risks are also known as unsystematic risks or firm-specific risks. While systematic risk rewards the firm with a return, there is no such return reward available against diversifiable or unsystematic risks. The market generally believes that diversifiable risks are completely hedged by each firm and the only risk to which a firm remains exposed is a market-risk or unsystematic risk.

Relationship b/w diversifiable and un-diversifiable risk are:

1. If we add diversifiable and un-diversifiable risk, we get the total risk that is Standard Deviation

2. Diversifiable risk is not rewarded whereas Un-diversifiable risk is rewarded.

3. Un-diversifiable risk is measured in terms of Beta. Market Beta is assumed to be 1. If a firm has beta greater than 1, it is considered riskier and vice-versa.

4. Example of diversifiable risk: If a firm operates in a building which is prone to fire, taking appropriate safety measures can remove such risk. This kind of risk is not rewarded by market because if some day the building catches fire and losses are incurred, these losses will not affect other businesses in the same domain. On the other hand, if the loss is incurred because of the market, every business will get affected.