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

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  • Ben-Horim, Moshe
  • Levy, Haim

Abstract

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:

Suggested Citation

  • Ben-Horim, Moshe & Levy, Haim, 1980. "Total Risk, Diversifiable Risk and Nondiversifiable Risk: A Pedagogic Note," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 15(2), pages 289-297, June.
    • Handle: RePEc:cup:jfinqa:v:15:y:1980:i:02:p:289-297_00
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    Cited by:

    1. Cranfield, John A.L., 2002. "Persistence Of Price-Cost Margins In The U.S. Food And Tobacco Manufacturing Industries: A Dynamic Single Index Model Approach," Journal of Food Distribution Research, Food Distribution Research Society, vol. 33(2), pages 1-16, July.
    2. Byeong-Je An & Andrew Ang & Turan G. Bali & Nusret Cakici, 2014. "The Joint Cross Section of Stocks and Options," Journal of Finance, American Finance Association, vol. 69(5), pages 2279-2337, October.
    3. Tony van Zijl, 1984. "A New Statement of the Extended Capital Asset Pricing Model," Australian Journal of Management, Australian School of Business, vol. 9(2), pages 67-86, December.
    4. Haensly, Paul J., 2020. "Risk decomposition, estimation error, and naïve diversification," The North American Journal of Economics and Finance, Elsevier, vol. 52(C).

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