Meaning and definition of idiosyncratic risk
The idiosyncratic risk can be defined as the risk which affects a very diminutive number of assets, and can be almost eradicated through diversification. It is quite similar to unsystematic risk. As explained by Investopedia, idiosyncratic risk is particular to a small number of stocks. One good example is an unexpected strike by the employees. Putting another way, idiosyncratic risk can be explained as the risk of change in prices because of unique circumstances of a particular security, as compared to the overall market.
Calculating idiosyncratic risk
The value of a company fluctuates with the expected growth and the level of profitability. The level of risk in operations plays a vital role in influencing the profitability level. The main steps involved in calculating the idiosyncratic risk are:
- Analyze the meaning of idiosyncratic risk, which includes four determinants – the macro-environment, the size of the firm or the company, and the industry.
- Compute the effect of size. Generally, the smaller the company, the higher is the risk. Determine the company’s size on a scale of 1-10 (starting from 1 as the smallest). One of the good measurements for size of company is market capitalization or total revenues.
- The next step involves calculating the effect of macro-environment and the industry. The macro-environment includes economic, socio-cultural, technological, international, demographic, and political risks, which are also the most important determinants of industry. The best technique to measure the impact of these risks is referred as SWOT analysis, particularly the “OT”, or the opportunities and threats fraction of the method. Estimate the effect, on a scale of 1-10, considering 1 as the highest risk level, of all the threats and opportunities on a given company.
- Compute the company’s risk. Generally, this is a task of the human capital of the company. It is also delineated by the general belief systems of those running a company. This is the reason for human capital being one of the most vital elements to profitability. It is a difficult thing to be measured on scale. However, good salaries and brands indicate good leadership. Assign a rating from a scale of 1-10 (1 being the indictor of poor brand and leadership).
- Add up the key determinants of idiosyncratic risk thus reaching the exact risk level. A higher rating indicates the lower risk.