Investments, tenth edition

  Firm-Specific Risk 

 The monthly standard deviation of HP’s residual is 7.67%, or 26.6% annually. This is quite 

large, on top of HP’s already high systematic risk. The standard deviation of systematic 

risk is  b   3   s (S&P 500)  5  2.03  3  13.58  5  27.57%. Notice that HP’s firm-specific risk is 

as large as its systematic risk, a common result for individual stocks.  

  Correlation and Covariance Matrix 

  Figure 8.4  graphs the excess returns of the pairs of securities from each of the three sectors 

with the S&P 500 index on the same scale. We see that the IT sector is the most variable, 

followed by the retail sector, and then the energy sector, which has the lowest volatility.  

 Panel 1 in  Spreadsheet 8.1  shows the estimates of the risk parameters of the S&P 500 

portfolio and the six analyzed securities. You can see from the high residual standard 

  

11

    SE(b)

5

s(e

HP

)

s

HP

"n 2 1

  

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8

 Index 

Models

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deviations (column E) how important diversification is. These securities have tremendous 

firm-specific risk. Portfolios concentrated in these (or other) securities would have unnec-

essarily high volatility and inferior Sharpe ratios.  

 Panel 2 shows the correlation matrix of the residuals from the regressions of excess 

returns on the S&P 500. The shaded cells show correlations of same-sector stocks, which 

are as high as .7 for the two oil stocks (BP and Shell). This is in contrast to the assumption 

of the index model that all residuals are uncorrelated. Of course, these correlations are, to 

 Figure 8.4 

Excess returns on portfolio assets  

−.3

−.2

−.1

.0

.1

.2

.3

0

10

20

30

40

50

60

Month

Monthly Rates (%)

S&P 500

HP

DELL

−.3

−.2

−.1

.0

.1

.2

.3

0

10

20

30

40

50

60

Month

Monthly Rates (%)

S&P 500

WMT

TARGET

−.3

−.2

−.1

.0

.1

.2

.3

0

10

20

30

40

50

60

Month

Monthly Rates (%)

S&P 500

BP

SHELL