For the firms with access to the global stock market, the use of the Sharpe-Lintner-Mossin CAPM that presumes market segmentation (Bekaert & Harvey, 1995) will tend to overestimate the cost of equity, since diversifiable risks
in a local market investment could now be diversified internationally (Stulz, 1999).
1986: Diversifiable risks in LDC lending: A 20/20 hindsight view.
As seen, the diversifiable risk component [w.sub.i.sup.2] will become smaller as securities are added to tire portfolio.
Fama and French argue that high average returns on small cap stocks and high book to market ratio stocks reflect unidentified state variables that produce non diversifiable risks
in returns and that are not captured by the market return and are priced separately from market beta.
Even worse, although covariant risks are difficult for any community to manage efficiently, research has also shown the informal risk-sharing mechanisms used by the poor are inefficient even for idiosyncratic, diversifiable risks
(see, e.g., Jalan and Ravallion, 1999).
By shielding directors from liability, the business judgment rule enables directors to ignore the diversifiable risks associated with various investment options and focus on expected value, which increases shareholder wealth.
Diversified shareholders "are indifferent to the levels of diversifiable risk associated with different projects." (72) They "view projects with identical levels of market risk and identical levels of expected returns as equivalent, even if the projects have very different levels of diversifiable risk." (73) For example, suppose that a corporation can choose between two potential projects.
For specific investment asset in a particular country, at least part of the political risks resulting from political violence-related policy changes are not diversifiable risks
. This is because investors cannot fully anticipate all contingencies and because the market for the securitization of political risks is not yet well developed; John Finnerty, "Securitizing Political Risk Insurance: Lessons From Past Securitization" in International Political Risk Management, ed.
The diversifiable risks
tend to be those more closely related to specific companies or securities, such as management risk and default risk.
Insurance is designed to build portfolios of diversifiable risks
and to hedge the systematic risk in these portfolios.
are those risks that may be protected against by using the law of large numbers.
Understanding the meaning of diversifiable and nondiversifiable risks may encourage the use of asset allocation (see Chapter 6) and other portfolio techniques to minimize diversifiable risk
in funds used for retirement income.