of Entrepreneurship, 100) Am.
(c) The capital asset pricing model (Sharpe, 1964) assets that a higher level of systematic or nondiversifiable risk
results in a higher expected rate of return.
Thus, catastrophic climate risk is a nondiversifiable risk
. And nondiversifiable risk
is different from insurable risks; it commands a risk premium determined by societal risk aversion.
(107) "Systematic risk is also known as nondiversifiable risk
In contrast, Wang (2003) and WBF (2009) show that, in a world with risk-averse investors, each reference rate should take account of the nondiversifiable risk
of the associated financial instrument.
and Levy, H., Total Risk, Diversifiable Risk and Nondiversifiable Risk
: A Pedagogic Note, Journal of Financial and Quantitative Analysis (June 1980)
(1997) (discussing strategies to hedge nondiversifiable risk
The risk-free rate would be an appropriate discount rate only if the adjustment that reflects the systematic risk (nondiversifiable risk
) is reflected in the expected cash flows.
They demonstrate useful equivalences between decision tree analysis and real option valuation when nondiversifiable risk
isn't great enough that it would change the investment decision; modeling risks explicitly in the cash flow projections and adding a country risk premium in the discount rate; and three ways to compute equity cash flows for the valuation of financial companies.
(20) Since the price of a security is determined by a firm's expected returns, as well as the degree of nondiversifiable risk
that accompanies those expected returns, (21) the firm's IPO prospectus must convey this information to the investors.
Beaver (1997), Feltham and Ohlson (1999), and others characterize equity value as a function that increases in expected future profitability and decreases in nondiversifiable risk
, all else equal.
The standard CAPM method says the required return on a risky asset such as common stock is related linearly to a nondiversifiable risk
, otherwise known as "systematic" risk.