This video shows the difference between systematic risk (market risk) and unsystematic risk (firm-specific risk, diversifiable risk). Unsystematic risk results from events that have a unique effect on a firm's stock price (e.g., the CEO is fired) while systematic risk results from common shocks that affect all firms (the U.S. Federal Reserve decides to cut interest rates). When an investor chooses to invest in a portfolio of different stocks, the firm-specific risks average out (one firm has a good event, while another has a bad event); the volatility (a measure of total risk) of the portfolio declines as more firms are added. This process is known as diversification. Because investors can eliminate firm-specific risk through diversification, they do not require a risk premium for firm-specific risk. This leads to the conclusion that it is systematic risk which effectively determines the cost of equity capital for a firm. To measure a firm's sensitivity to systematic risk (market risk), we can examine a firm's beta. Once we know the beta, we can estimate the firm's cost of equity capital using the Capital Asset Pricing Model.
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