The role of unsystematic risk in financial markets – RUFM

The proposed research project undertakes a comprehensive analysis of the role of unsystematic risk within the realm of financial markets. In contrast to prevailing conventional wisdom, which posits that only systematic risk is rewarded in financial markets, our investigation substantiates, both theoretically and empirically, that unsystematic risk harbors a discernible price of risk. Subsequently, we undertake a meticulous examination of the implications of this paradigm-shifting insight on several critical facets of financial markets, namely: (i) the cross-section of asset returns, (ii) the performance of active asset managers, (iii) the dynamic properties of asset-pricing anomalies, and (iv) the segmentation of asset markets.

Our primary theoretical contribution resides in the transformation of the conventional risk-return tradeoff paradigm governing asset markets. Additionally, we provide a comprehensive framework for the accurate measurement of risk-adjusted returns. The principal empirical outcome of our analysis is the demonstration of the substantial quantitative significance associated with the compensation for unsystematic risk, a dimension heretofore ignored in the existing body of literature. These insights have far-reaching implications for portfolio choice, asset pricing, and risk management, which we study in a series of independent research papers. This research offers a substantial advancement in the understanding of financial markets and underscores the critical importance of reassessing the risk-reward tradeoff, fostering innovative perspectives, and catalyzing transformative change in the field of finance.