Systematic risk

Systematic risk is a term reffered to very often in economics, specifically in finance. It is risk that cannot be eliminated through diversification, therefore it may also be called undiversifiable risk or aggregate risk. This term refers to vulnerability to events that aggregately affect the whole economy. It reflects the impact of distinctive economic, geopolitical as well as financial factors on the entire market and its pervasive, farreaching results. Due to its nature it is hard to be predicted and almost imossible to be avoided.

Comparison of systematic risk and unsystematic risk

The general term of total risk can be viewed as existing of two opposing elements:

  • systematic risk,
  • unsystematic risk.

The difference between those two components is very clear. Unsystematic risk is the proportion of risk associated with some random causes attributable to specific firm or industry. Due to its idiosyncratic nature it can be easily diversified by creation of portfolio. It may be reduced or at least controlled with the use of specific preventive actions. Under its interpretation it covers terms gathered under financial or business risk consideration. Therefore, from the point of view of the company's operations examples of unsystematic risk may include: strikes, lawsuits, as well as liquidity or credit risk. On the other hand, systematic risk is a probablility or threat of damage to the whole system occuring due to macroeconomic factors. Shocks arising in this process due to dynamic market structures are faced up by all agents and entities. The lack of mechanisms capable in predicting this issue often makes many market investors solely concerned with undiversifiable risk. Examples of such unplanned systematic risk events include : war, international incidents, overal state of the economy or political affairs. Although, the most important example in the history of modern economy certainly was the Great Recession that started in 2008[1].

Types of systematic risks

Systematic risk is an extremely broad approach. It is the macroeconomic concept associated with a wide spectrum of aspects including economic, social, legal and political factors. Therefore, among undiversifiable risks it is possible to distinguish more precise categories, namely[2]:

  • Market risk – It is a possibility of ocurring certain losses due to changes in market forces, which are beyond control. To some extent it is also connected with the mentality of investors, who often tend to follow the direction of the market.
  • Interest rate risk – Interest rates are the main and most imortant characteristic governing the valuation of securities. Therefore their corrections performed by goverment cause the uncertainty of future market values.
  • Purchasing power or inlation risk – Inflation is a persistent increase in general level of prices therefore it erodes the purchasing power of money.
  • Exchange rate risk – This factor has increased its importance in the era of globalisation. Currently most of the entities in the economy have certain exposure to foreign currencies and therefore are subject to their fluctuations.

Beta and systematic risk

Systematic risk while being discussed is described as an aggregated risk generated by combined external uncertainty factors. Due to its complex nature it has significant implication on general economic growth. For this reason, many investors are solely concerned with measurement of nondiversifiable risk that will allow them to choose assets with the best and most profitable risk–return characteristics. To some extent, it is possible to be achieved using CAMP ( capital asset pricing model), which matches systematic risk to linked expected returns. This model deals with beta coefficient, which may be said to constitute a relative measure of systematic risk. It is used to explain the relationship between particular investment’s returns and market index returns. Negative value of beta coefficient indicates that investment is in contrary movement to the market and hence to the nondiversifiable risk [3].

Footnotes

  1. L. J. Gitman (2012) Principles of Managerial FInance, Published by Prentice Hall, p. 329-330
  2. H. Kent Baker, G. Filbeck (2015)Investment Risk Management, Published by Oxford University Press, p. 308-316
  3. P. Periasamy (2009)Financial Management , Published by McGraw Hill Education, p. 33-34

References

Author: Paulina Załubska