Question

Please, identify and discuss some types of firm-specific factors that increase a firm’s non-diversifiable risk (systematic risk). Also, identify and discuss some of firm-specific factors that increase a firm’s diversifiable risk (specific risk). Why do models of risk-adjusted expected returns include no expected return premia for diversifiable risk?

Answer 1

Ans :-
A Systematic risk refers to the risk inherent to the entire market . It is also known as “undiversifiable risk,” “volatility” or “market risk,” affects the overall market, not just a particular stock or industry. This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification, only through hedging or by using the correct assets allocation strategy.

The Firm-specific factors that increase the firm's nondiversifiable risk (systematic risk) include the firm's exposure to economy-wide risk factors such as interest rate changes, inflation, foreign exchange rate changes, and cyclicality. Firm-specific exposure to such risk factors is determined by factors such as the firm's leverage, extent of fixed versus variable interest rate debt and investments, and the extent of exposure to foreign exchange rate fluctuations.

The types of firm-specific factors that increase the firm's diversifiable risk (idiosyncratic risk or nonsystematic risk) include the firm's exposure to competition, technological change, labor problems, management competence, and operating control. Models of risk-adjusted expected returns include no expected return premia for diversifiable risk because, in theory, a risk-averse investor can avoid the positive and negative consequences of these types of risks on his or her portfolio through portfolio diversification.