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:
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.