Idiosyncratic Risk

Idiosyncratic risk, sometimes referred to as security-specific risk, is risk that cannot be accounted for by other risk factors. Importantly, this is risk that cannot be hedged using other instruments.

A standard dichotomy divides the risk of an equity into market risk and idiosyncratic risk. This can be done using standard regression analysis. If Rt is the return at time t of a portfolio, and Rm,t is the return at time t of the market, then we have:

Rt = α + βRm,t + εt

where, α and β are constants, and εt is a mean zero error term. The first part of the right-hand side, α + βRm,t, represents the systematic component of Rt. The error term, ε, represents the idiosyncratic component of Rt.

The total variance of the portfolio is equal to the systematic variance plus the idiosyncratic variance.

 

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