17-Capital Asset Pricing Model Page 515 Wednesday, February 4, 2004 1:10 PM
Capital Asset Pricing Model 515Notice that the portfolio variance does not depend on the variance of
the assets comprising the market portfolio but on their covariance with
the market portfolio. Sharpe defines the degree to which an asset cova-
ries with the market portfolio as the asset’s systematic risk. More specif-
ically, he defined systematic risk as the portion of an asset’s variability
that can be attributed to a common factor. Systematic risk is the mini-
mum level of risk that can be obtained for a portfolio by means of diver-
sification across a large number of randomly chosen assets.
As such, systematic risk is that which results from general market
and economic conditions that cannot be diversified away. Sharpe
defined the portion of an asset’s variability that can be diversified away
as nonsystematic risk. It is also sometimes called unsystematic risk,
diversifiable risk, unique risk, residual risk, and company-specific risk.
This is the risk that is unique to an asset.
Consequently, total risk (as measured by the variance) can be parti-
tioned into systematic risk as measured by the covariance of asset i’s
return with the market portfolio’s return and nonsystematic risk. The
relevant risk is the systematic risk. We will see how to measure the sys-
tematic risk later. How diversification reduces nonsystematic risk for
portfolios is illustrated in Exhibit 17.1. The vertical axis shows the vari-
ance of the portfolio return. The variance of the portfolio return repre-
sents the total risk for the portfolio (systematic plus nonsystematic).EXHIBIT 17.1 Systematic and Unsystematic Portfolio Risk