Why do models of risk-adjusted expected returns include no expected return premia for diversifiable risk?
This question calls for distinction between systematic risk and unsystematic risk. Systematic risk refers to the risk associated with an entire market. Unsystematic risk, which is also called idiosyncratic risk, refers to the risk associated with a specific firm or security.
Answer and Explanation:
Unsystematic, firm-specific, risk can be diversified away via prudent portfolio construction. A broad collection of less than perfectly correlated securities can mitigate the unsystematic risk inherent in each. Adverse events and price movements for some securities will be offset by favorable developments for other securities, leaving the portfolio unaffected in aggregate.
This is why models of risk-adjusted returns do not include a premia for diversifiable risk. The presumption is that a prudent investor will capitalize on the benefits of diversification. Moreover, since idiosyncratic risk can essentially be achieved for free, risk-adjusted return models do not reflect any compensation for it.
Incidentally, systematic, market-wide, risks cannot be diversified away. They include the impact of inflationary changes, interest rate changes, and broad movements in equities, commodities, and foreign currency markets. These risks can only be reduced through hedging or by using an appropriate asset allocation strategy.
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from Finance 305: Risk ManagementChapter 3 / Lesson 8