Explain the components of the total risk of a security. Provide necessary examples for each component of risks.

Total risk of a security comprises two components: (i) Systematic Risk or Non-Diversifiable Risk Systematic risk is the risk which is caused by factors beyond the control of specific company, such as general factors in the market, GDP, inflation, interest rates, tax policy, government policy, etc. These factors affect all the companies and cause variability in their returns. Systematic risk cannot be reduced by holding an efficiently diversified portfolio. Therefore, systematic risk is that part of total risk which cannot be eliminated by diversification. However, the systematic risk may be managed by ensuring that the portfolio includes a variety asset classes, like fixed income, cash and real estate, each of which will react differently in the event of a major systemic change. Systematic risk of a security is indicated by beta coefficient (β). β captures the sensitivity of a security's return with respect to market return. (ii) Unsystematic Risk or Diversifiable Risk It is that part of total risk which is diversifiable. It is caused by factors which are within the control of a specific company, such as management, operational efficiency, labour conditions and financial leverage. The sources of unsystematic risk are business risk and financial risk. Securities which are less than perfectly and positively correlated can be combined together to diversify away unsystematic risk. It can be observed that unsystematic risk can be reduced to zero in an efficiently diversified portfolio; hence the only relevant risk in such a portfolio is systematic risk. As per CAPM there is a linear and positive relationship between expected return and systematic risk measured by β. CAPM is used to estimate expected return from a security or portfolio. β measures the sensitivity of a security's returns to the return of market portfolio. Some securities are less sensitive while others are more. Hence β of different securities and portfolios are also different. Moreover, unsystematic risk of a security can be diversified away, hence investor will not receive any return or risk premium for bearing unsystematic risk. The investor will receive risk premium only for the systematic risk identified by β.