Thursday, 19 February 2015

Fundamental Risk versus Systematic Risk

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Fundamental Risk versus Systematic Risk

Some might expect a conflict between the market measure of risk (systematic risk) and the fundamental determinants of risk (business risk, and so on). A number of studies have examined the relationship between the market measure of risk (systematic risk) and accounting variables used to measure the fundamental risk factors, such as business risk, financial risk, and liquidity risk. The authors of these studies have generally concluded that a significant relationship exists between the market measure of risk and the fundamental measures of risk. 10 Therefore, the two measures of risk can be complementary.

This consistency seems reasonable because, in a properly functioning capital market, the market measure of the risk should reflect the fundamental risk characteristics of the asset. As an example, you would expect a firm that has high business risk and financial risk to have an above average beta. At the same time it is possible that a firm that has a high level of fundamental risk and a large standard deviation of return on stock can have a lower level of systematic risk because its variability of earnings and stock price is not related to the aggregate economy or the aggregate market.

Therefore, one can specify the risk premium for an asset as:

Risk Premium = f (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country Risk)

Or

 Risk Premium = f (Systematic Market Risk)

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