{"id":7617,"date":"2022-04-01T13:41:05","date_gmt":"2022-04-01T12:41:05","guid":{"rendered":"https:\/\/www.simtrade.fr\/blog_simtrade\/?p=7617"},"modified":"2022-04-01T13:41:05","modified_gmt":"2022-04-01T12:41:05","slug":"specific-risk","status":"publish","type":"post","link":"https:\/\/www.simtrade.fr\/blog_simtrade\/specific-risk\/","title":{"rendered":"Specific risk"},"content":{"rendered":"

\"Youssef_Louraoui\"<\/a><\/p>\n

In this article, Youssef LOURAOUI<\/a> (Bayes Business School, MSc. Energy, Trade & Finance, 2021-2022) explains the specific risk of financial assets, a key concept in asset pricing models and asset management in practice.<\/p>\n

This article is structured as follows: we start with a reminder of portfolio theory and the central concept of risk in financial markets. We then introduce the concept of specific risk of an individual asset and especially its sources. We then detail the mathematical foundation of risk. We finish with an insight of the relationship between diversification and risk reduction with a practical example to test this concept.<\/p>\n

Portfolio Theory and Risk<\/h2>\n

Markowitz (1952) and Sharpe (1964) created a framework for risk analysis based on their seminal contributions to portfolio theory and capital market theory. All rational profit-maximizing investors attempt to accumulate a diversified portfolio of risky assets and borrow or lend to achieve a risk level consistent with their risk preferences given a set of assumptions. They established that the key risk indicator for an individual asset in these circumstances is its correlation with the market portfolio (the beta).<\/p>\n

The variance of returns of an individual asset can be decomposed as the sum of systematic risk and specific risk. Systematic risk refers to the proportion of the asset return variance that can be attributed to the variability of the whole market. Specific risk refers to the proportion of the asset return variance that is unconnected to the market and reflects the unique nature of the asset. Specific risk is often regarded as insignificant or irrelevant because it can be eliminated in a well-diversified portfolio.<\/p>\n

Sources of specific risk<\/h2>\n

Specific risk can find its origin in business risk (in the assets side of the balance sheet) and financial risk (in the liabilities side of the balance sheet):<\/p>\n

Business risk<\/h3>\n

Internal or external issues might jeopardize a business. Internal risk is directly proportional to a business’s operational efficiency. An internal risk would include management neglecting to patent a new product, so eroding the company’s competitive advantage.<\/p>\n

Financial risk<\/h3>\n

This pertains to the capital structure of a business. To continue growing and meeting financial obligations, a business must maintain an ideal debt-to-equity ratio.<\/p>\n

Mathematical foundations<\/h2>\n

Following the Capital Asset Pricing Model (CAPM), the return on asset i<\/i>, denoted by Ri<\/sub> can be decomposed as<\/p>\n

\"img_SimTrade_return_decomposition\"<\/p>\n

Where:<\/p>\n