On Systematic and Unsystematic Components of Financial Risk

THE RELATION between the characteristics of uncertain cash flows and their equilibrium prices in perfect capital markets is one of the main topics of analysis in the theory of finance. Within this context, the issue of the existence of "unsystematic" risks has aroused considerable interest and controversy. One way of defining the problem can be the following: is it possible to consider all financial prospects as sums of two components, so that one-the systematic component-is perfectly correlated among all securities, and the other-the residual or unsystematic component-is uncorrelated with the first and does not affect the price of the prospect? The origin of the controversy is the apparent disagreement between the results of Sharpe [10] and Lintner [7]. Sharpe was first to consider the idea and he also coined the term "systematic." Given certain assumptions about the market, Sharpe's answer to the question as posed above is in the affirmative. Furthermore, the systematic component is shown in Sharpe's analysis to be perfectly correlated with the market portfolio, which is composed of all outstanding securities. Lintner's conclusions on this issue are exactly the opposite, namely: "Other things being equal, stock values.... will always vary inversely with the residual variance (or "standard error of estimate") of their regression on either external index of business conditions or the composite market preformance of the entire group of stocks composing the market" [7, p. 588]. In a comparative analysis of the two studies, Fama [4] distinguishes two different models in Sharpe's article. He shows the first-the capital asset pricing model-to be in complete agreement with Lintner's model. Fama calls the second model the market model, and shows that the assumptions implicit in it are inconsistent. As for the issue of systematic and unsystematic risk, Fama seems to adopt Lintner's position that unsystematic risks (as defined above) cannot exist. The present note is an additional (and probably not the last) chapter in this altogether intriguing discussion. We shall show that the so called "market model" can best be interpreted as an alternative presentation rather than a set of assumptions comprising a "model." Under the suggested interpretation, Sharpe's original result holds. The issue of systematic risk is then analyzed in the light of results derived by this author elsewhere [2]. It is shown that systematic and unsystematic components can be identified whenever equilbrium prices exist, regardless of