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.

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:

• 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 .

Examples of Systematic risk

• Macroeconomic Factors: Macroeconomic factors are factors that affect the economy as a whole, including Gross Domestic Product (GDP), inflation, and interest rates. These factors have a direct impact on company performance and stock prices, making them an example of systematic risk. For example, an unexpected change in interest rates could cause companies to suffer from reduced profits, leading to a decrease in stock prices.
• Political Risk: Political risk is a risk associated with the possibility of a change in government policies or instability in a country. This can have a direct impact on the performance of companies operating in that country, and can cause stock prices to fluctrate. For example, a change in tax policies or tariffs could lead to decreased profits or increased cost of operations, resulting in lower stock prices.
• Natural Disasters: Natural disasters such as floods, earthquakes, and hurricanes can have a devastating impact on businesses, leading to decreased profits and stock prices. For example, the damage caused by Hurricane Katrina in the Gulf Coast region of the United States led to massive losses for businesses operating in the area, leading to a decrease in stock prices.

Limitations of Systematic risk

• Systematic risk is difficult to protect against: Systematic risk is pervasive and can not be diversified away, as it is not specific to any one company or sector. Therefore, it cannot be hedged or insured against.
• Systematic risk is hard to predict: Systematic risk is caused by events that are hard to anticipate, such as geopolitical events or changes in economic policies. This makes it difficult to predict when these events will occur, making it impossible to prepare for them.
• Systematic risk is hard to measure: The magnitude of systematic risk is hard to measure, as it affects the entire market. This makes it difficult to quantify and assess the degree of risk associated with it.
• Systematic risk is hard to manage: As systematic risk is pervasive, it is hard to manage. Risk management strategies are limited and may not be effective in mitigating systematic risk.

Other approaches related to Systematic risk

The other approaches related to Systematic risk include:

• Market Risk: This type of risk is associated with the overall movement of the market, and is also known as non-diversifiable risk or undiversifiable risk. It affects the entire market and is caused by factors such as economic conditions, political instability and interest rate changes.
• Operational Risk: This type of risk is associated with the day-to-day activities of a company, such as the risk of an unexpected failure in a system or process. It can also include the risk of errors, fraud and other external events that could interfere with the normal operations of the business.
• Credit Risk: This type of risk is associated with the risk of default by a borrower, such as a customer or supplier. It is a form of financial risk and is often caused by borrowers not being able to make timely payments.

In summary, Systematic risk is a type of risk that affects the entire market and is caused by factors such as economic conditions, political instability and interest rate changes. Other approaches related to Systematic risk include Market Risk, Operational Risk and Credit Risk. These risks are associated with the overall movement of the market, the day-to-day activities of a company and the risk of default by a borrower.

Footnotes

Systematic risk — recommended articles

Economic risk — Country risk — Market disruption — Cost risk — Total risk — Market condition — Opportunities and threats — Operational impact — Translation Risk

References

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

Author: Paulina Załubska