CORPORATE
VALUATION RISK 6-27
Systematic and Unsystematic Risk
Expected vs.
uncertain return
To evaluate the risk associated with an individual security or a
portfolio of securities, the realized return to investors must be
broken into two parts:
1) Expected return
2) Uncertain return
Expected return
based on
current market
factors
For a stock (equity security), the expected return is the part that
investors and analysts can predict. These predictions are based on
information about current market factors that will influence the stock
in the future. We discussed this process in Unit Two in our
discussion on interest rates. By studying external and internal factors
that affect a company's operations, analysts can assess how each
factor may affect the company. The stock price of a company is
determined by expectations of a company's future prospects based on
the influence of all factors.
Uncertain
return
influenced by
unexpected
factors
The other part of the return of a stock is the uncertain or risky part
that comes from unexpected factors arising during the period. For
example, an unexpected research breakthrough may cause a
company's stock to rise; a sudden, unexpected rise in inflation rates
may cause a company's stock to fall.
Company
specific,
diversifiable
risk
These two parts of the realized return translate into two types of risk:
(1) risk specific to a single company or a small group of companies,
and (2) risk that affects all companies in the market.
In the stock W and stock Y example, when we created a diversified
portfolio to eliminate some of the risk associated with each stock,
we eliminated the company-specific risk. This type of company-
specific, diversifiable risk is called unsystematic risk.