6.3 Risks are of two types, viz., (i) Diversifiable, and (ii) Non-diversifiable.
6.4 Diversifiable Risk is also known as Unsystematic Risk. This represents the
elimination or minimization of risk through diversification. It is called
unsystematic because risk factors are treated as individual to each firm, and
therefore factors which cause risk vary from firm to firm. Factors that influence
risks are quality of management decisions, competitions in the market, using of
leverages, rules and regulations, strikes, transport, location etc.
6.5 Factors that commonly influence risk of all firms are known as non-diversifiable
risks or systematic risks. For example, inflation, economic policy, change in
Government, changes in law, interest rate etc.
6.6 An investor can adopt the strategy of diversification to eliminate or reduce the
unsystematic risk. Therefore, the focus of the following sections is on non-
diversifiable risk.
6.7 According to CAPM approach, non-diversifiable risk can be measured in relation
to the market portfolio. Non-diversifiable risk will be assessed in terms of the beta
co-efficient. The movements of return in respect of a particular security related to
returns of market portfolio are a measure of beta. In other words, beta measures
the movement or change in return on a security in response to changes in market
return. Therefore beta is an index of the degree of responsiveness of return on an
investment with the market return. The market index shows the beta for the
market portfolio. It will be measured by the broad-based market index.
6.8 A zero co-efficient indicate zero market related risk for the investment. A beta
co-efficient equal to one indicates that the risk of a security is equal to the market
risk. If the beta co-efficient is less than one, risk of a security and a market risk
varies inversely. The required rate of market return for a given amount of
systematic risk is known as the SML (security market line).
6.9 The CAPM explains the relationship between the cost of equity and the relevant
risk of the firm as reflected in its index of non-diversifiable risk. The risk as
shown in beta to determine the cost of equity will be considered by the CAPM.
- Rational of the CAPM
7.1 Investors are always risk averse and try to eliminate risk. The risk is known as
residual risk or alpha. This, they will do by holding a diversified portfolio of
assets. Alpha risks are specifically associated with individual assets. The
diversification of assets will reduce the risk. Certain risks like, say, recession is a
non-diversifiable risk and it is not possible to eliminate it. The investor's
expectation of returns will also be above the average of return on safer
investments. The valuation of any particular asset depends on the effect of the