Stulz chapter 2

[harmeetsokhi]

Hi David,

I want to know what is the basis of the assumption that "the investors can diversify themselves, won't pay for this"?
Is this due to some information gap that results in this assumption?
My understanding is that managing the systematic risk requires more expertise and knowledge rather than the idiosyncratic risk.
Please throw some light on this.

Regards

 

[David Harper CFA FRM]

Harmeet,

I think i tried to stress that Chapter 2 in Stulz is really all about CAPM; it's sort of a fantasy world that exists if the CAPM assumptions are true. So, Stulz assertion that risk mgmt can't add value by reducing idiosyncratic risk is an extension of CAPM. For example, assume two firms:

Firm R ("risky") has systematic risk such that beta = 2.0 but no idiosyncratic risk; and
Firm S ("riskier") has also has systematic risk such that beta = 2.0 but also has significant idiosyncratic risk

CAPM says the value of both firms is the same, both are expected cash flow discounted by same discount rate because the discount rate is solely a function of systematic risk: discount rate = riskfree + (2)*ERP.

If you manage Firm S and cleverly reduce its idiosyncratic risk to zero, CAPM says: investors don't change the price they will pay for your future cash flow. They can diversify in their own portfolios so "they won't pay you" with a higher premium (lower discount rate) to reduce that risk. In CAPM-world, moving the idiosyncratic risk needle finds no reward with higher firm price.

Re: "My understanding is that managing the systematic risk requires more expertise and knowledge rather than the idiosyncratic risk."

That's interesting, I don't have a pat answer, In the Stulz Chapter 2 clinical CAPM-world, Stulz easily reduces systematic risk by shorting index futures. (i.e., one problem with CAPM is the SINGLE-FACTOR assumption that everybody is exposed to the same common risk factor: the market premium). When the world is single-factor, it seems like reducing systematic risk is easy.

At the same time, IMO "systematic" risk has a broader meaning (something like: correlation to shared market factors) and, in that sense, I could see an argument to support your statement. It would be further supported by something like: idiosyncratic risks are native to the company so they are easier to manage by its own employees...

David

 

[harmeetsokhi]

Thanks David for the detailed solution.

 

[David Harper CFA FRM]

sure thing, i was thinking further about your point about systematic risk reduction and, if you flip it around, i find it instructive:

The fact that Stulz (in his gold firm example) can reduce the gold firm's systematic risk by shorting the market (short index forward) seems to me a great perspective on the CAPM in all its strange glory. Of course that won't work in practice, it requires the fanciful idea that the firm's only risk is exposure to the same common factor (the market premium) to which the index instrument is exposed. It's just a great illustration that the CAPM is a sadly one-factor model.