Are idiosyncratic and business risk the same?

[Sergio Guerrero]

Hi: I signed up a few days ago and just finished reading the Crouhy study-notes and was wondering if this so called idiosyncratic or specific risk is the same as businness risk. I hope to be making proper use of this forum and of this tool. May I place any question here? What is a thread? Thank you very much in advance, Sergio

 

[Matthew Graves]

In my practical experience, idiosyncratic risk tends to take on a very specific meaning. In the context of a risk model it is the portion of the total risk for each issuer/entity that is not explained by the factors in the model i.e. is specific to that issuer/entity. Business risk is the risk that the issuer/entity will have lower than anticipated profits. You can see that the two are likely related but the definitions are quite distinct.

For example, if a company is facing a specific business risk (e.g. their one and only supplier is insolvent) then it is likely that this will translate into greater idiosyncratic risk in a risk model for that company. However, imagine a situation where all companies in a sector are facing a similar business risk (e.g. global oil price is much lower than anticipated), it is likely that this business risk will be captured in an underlying credit factor rather than the idiosyncratic risk for each company.

Hope that helps. Apologies if I've made things worse by bringing factor models into the mix! I find it easier to describe the difference with a practical example.

 

[Nicole Seaman]

Hi: I signed up a few days ago and just finished reading the Crouhy study-notes and was wondering if this so called idiosyncratic or specific risk is the same as businness risk. I hope to be making proper use of this forum and of this tool. May I place any question here? What is a thread? Thank you very much in advance, Sergio

Hello @[email protected]

Welcome to Bionic Turtle! Yes, you have posted in the correct place. A thread is exactly what you have created here. It is a post that you create to ask a question. There are nine topics in the FRM curriculum, so there are nine topic sections in the forum. We just ask that you make sure to post your question in the correct topic section (which you have) and that you use the search function to make sure that someone else has not asked the same question already. Here is the link to one of our blogs about utilizing our forum to enhance your FRM studies: https://www.bionicturtle.com/utilizing-the-bionic-turtle-frm-forum/. We have some amazing forum members who are always there to help answer questions, and David is in the forum every day to explain things in-depth.

Nicole

 

[David Harper CFA FRM]

Hi @[email protected] Welcome! I agree fully with @Matthew Graves with respect to idiosyncratic (specific) risk. Per his explanation, I think invoking factor models may be the only reliable context; that is, the idea of idiosyncratic risk presumes there is a "non-specific" set of common factors (or even just one, in the CAPM). So, I think "specific" goes hand in hand with non-specific (common factors). Crouhy introduces idiosyncratic risk classically, as the risk which can be diversified away, so where a single factor model (eg, CAPM) has R(i) = α+β*F + e(i), which is the return function, the idiosyncratic risk is σ^2[e(i)]; ie, the variance of the specific component. Much of portfolio theory hinges on the idea that a well-diversified portfolio effectively eliminates this specific risk. That's important so we don't forget specific risk when the portfolio is not well-diversified.

I perceive "business risk" is more general and actually may vary a bit by author. I think it's possible some authors are referring to specific risk when they write business risk. Also, I've seen it used the way Matthew refers to. However, in the context of the long-term continuity of the FRM, I recently updated my risk typology (see below) which integrates Crouhy with Jorion. At a high level, we always used to parse the firmwide risks into business versus financial, such that the FRM is concerned with financial risks but not strategy and reputation (which are business risks). It appeals to me I guess because "business risk" for me is not sufficiently specific (pun intended ). I find business risk very general. For example, presumably it includes the risk of disruption, which is certainly profound but very difficult by definition to quantify. I hope that's helpful!

 

[Sergio Guerrero]

Thank you very much Matthew!

 

[Thomas Obitz]

Business risk is typically associated with the impact of the organisation's decisions and the market environment on its revenue streams and profitabilitity. It is therefore internal to the organisation carrying the risk.

Idiosyncratic risk is generally the risk component specific to one entity. If you look at it through the CAPM lens (as David explained it), it is a component of equity risk , hence an investment risk and therefore external to the organisation carrying the risk.

The business risk taken by one organisation contributes to the idiosyncratic risk for another organisation investing into it.

It is also worth mentioning that the breakdown of risks into "idiosyncratic" and "systemic" components applies in several risk categories - David explained the decomposition of equity risk in the CAPM, interest rate risk has a component of "general interest rate risk" and "specific risk" (in Basel II)/credit spread risk (FRTB), operational risk events can sometimes be systemic (natural disasters, war).

 

[emilioalzamora1]

I am citing C. Diderich 'Positive Alpha Generation' (Wiley) here where he mentions the following with respect to idiosyncratic risk.

Idiosyncratic (diversifiable, non-market) risk: the risk specific to asset 'a'.

Emphasis mine: The CEO of Coca Cola falls under a bus and dies. This will have some (or a major) impact on the stock price of Coca Cola. The CEO is of idiosyncratic nature to the success/failure of Coca Cola and therefore investors are concerned about the development of the firm if the CEO is no more.
As a result, this risk can be diversified away if an investor 1.) does not hold Coca Cola at all 2.) attaches only a minimum weight to Coca Cola.

Furthermore, W. Sharpe in his book 'Investors and Markets' (p.193-94): writes:

'The non-factor or residual risk due to uncertainty about the outcome for the ei term is considered to be idiosyncratic to the security or portfolio in ques- tion. Given this assumption, it follows that a portfolio with a large number of
securities will have relatively little idiosyncratic risk, owing to the effects of diversification'

With respect to the latter, this stems from W. Sharpe (1972) 'Diversification of non-market risk'.

Key message of Sharpe: 'The diversification becomes negligible once the portfolio reaches approx. 25-30 securities'

In my point of view:

• business risk: is more the risk the firm faces itself (entering unchartered territories/markets and so forth).
• idiosyncratic risk: is more the risk from an investor's viewpoint (does the new strategy proposed by CEO at the annual meeting pan out; how much effect has a major election on the stock price of firm XYZ).

In addition, these are two good reference readings:

Bali (2005): http://www.cfapubs.org/doi/pdf/10.2469/dig.v36.n1.1818
Cambpell (2001): 'Have Individual Stocks become more volatile?': http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.364.7413&rep=rep1&type=pdf

 

[Thomas Obitz]

Just to clarify in it comes up in the exam - litigation risk is a category of operational risk under Basel taxonomy. Outstanding receivables are credit risk. New markets are indeed deemed business risk.

 

[emilioalzamora1]

It was a rough example. I was simply differentiating between idiosyncratic vs. business risk and not talking about any subsets of risks.
Business risk is an overarching (all encompassing) term and it can be every sort of risk when the business starts it's operation on day 1.

 

[Hesham_87]

why trading risk (including general and specific risks) is classified under interest rate risk rather than equity price risk?

 

[ShaktiRathore]

Hi
Interest rate risk can arise on Balance sheet that is difference in Asset and Liabilities(gap) can vary based on fluctuations in the interest rate as assets and Liabilities react differently to the changing interest rates,also the interest rate risk could arise in trading book whereby the bond price can decrease dueto increase in interest rate(market risk) or due to credit deterioration of the firm(specific risk).
thanks