Topic 31
Unsystematic Risk
Topic 31 explores the factors giving rise to unsystematic risk. Unsystematic risk has its foundation in the operating risk of conducting business in its markets and is not captured in beta. Theoretically, unsystematic risk can be mitigated by holding broadly diversified portfolios of many securities. For any one security, unsystematic risk remains evident.
UNSYSTEMATIC RISK DEFINED
- Unsystematic risk is a composite driver of the return on a security due to operating conditions associated with and indigenous to the target business in its markets and industry.1 It may include factors such as:
- Sustainable competitive advantage or disadvantage resulting from technology changes
- Predatory competitors
- Relative product quality and functionality (relative to competition)
- Relative manufacturing efficiency
- Labor unrest and labor management
- Vulnerability to technological replacement (products or services)
- Management strength and depth
- Research and development competence
- Financing reach and viability
- Customer base and depth
- Although the market's perception of the company's control over the impact of such risks is reflected in a securities market valuation, beta does not capture these effects in equity risk premium (ERP) determination.
- Although the impact of an entity's unsystematic risk should be considered in the valuation of the target by modeling the effect on free cash flow, practitioners often make subjective adjustments to the discount rate for such risk ...
