Define systematic and unsystematic risk. what method is used to measure a single asset risk?
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Risk caused by factors beyond the control of a company or individual Systematic risk is that part of the total risk that is caused by factors beyond the control of a specific company or individual. Systematic risk is caused by factors that are external to the organization. All investments or securities are subject to systematic risk and, therefore, it is a non-diversifiable risk. Systematic risk cannot be diversified away by holding a large number of securities. Types of Systematic RiskSystematic risk includes market risk, interest rate risk, purchasing power risk, and exchange rate risk. Market RiskMarket risk is caused by the herd mentality of investors, i.e. the tendency of investors to follow the direction of the market. Hence, market risk is the tendency of security prices to move together. If the market is declining, then even the share prices of good-performing companies fall. Market risk constitutes almost two-thirds of total systematic risk. Therefore, sometimes the systematic risk is also referred to as market risk. Market price changes are the most prominent source of risk in securities. Interest Rate RiskInterest rate risk arises due to changes in market interest rates. In the stock market, this primarily affects fixed income securities because bond prices are inversely related to the market interest rate. In fact, interest rate risks include two opposite components: Price Risk and Reinvestment Risk. Both of these risks work in opposite directions. Price risk is associated with changes in the price of a security due to changes in interest rate. Reinvestment risk is associated with reinvesting interest/ dividend income. If price risk is negative (i.e., fall in price), reinvestment risk would be positive (i.e., increase in earnings on reinvested money). Interest rate changes are the main source of risk for fixed income securities such as bonds and debentures. Purchasing Power Risk (or Inflation Risk)Purchasing power risk arises due to inflation. Inflation is the persistent and sustained increase in the general price level. Inflation erodes the purchasing power of money, i.e., the same amount of money can buy fewer goods and services due to an increase in prices. Therefore, if an investor’s income does not increase in times of rising inflation, then the investor is actually getting lower income in real terms. Fixed income securities are subject to a high level of purchasing power risk because income from such securities is fixed in nominal terms. It is often said that equity shares are good hedges against inflation and hence subject to lower purchasing power risk. Exchange Rate RiskIn a globalized economy, most companies have exposure to foreign currency. Exchange rate risk is the uncertainty associated with changes in the value of foreign currencies. Therefore, this type of risk affects only the securities of companies with foreign exchange transactions or exposures such as export companies, MNCs, or companies that use imported raw materials or products. Calculation of Systematic Risk (β)Systematic risk is that part of the total risk that is caused by factors beyond the control of a specific company, such as economic, political, and social factors. It can be captured by the sensitivity of a security’s return with respect to the overall market return. This sensitivity can be calculated by the β (beta) coefficient. The β coefficient is calculated by regressing a security’s return on market return. The estimated equation is given below: RS is the return on a particular security while RM is the market return. It can be observed that β is the regression coefficient of RS on RM. The intercept term α shows a security’s return independent of market return. The value of β can be calculated using the following formula: The Beta of a stock or portfolio measures the volatility of the instrument compared to the overall market volatility. It is used as a proxy for the systematic risk of the stock, and it can be used to measure how risky a stock is relative to the market risk. When used as a proxy to measure systematic risk, the β value of a portfolio can have the following interpretation.
Additional ResourcesThank you for reading CFI’s guide on Systematic Risk. To better understand various investment risks, CFI offers the following resources:
Difference Between Systematic Risk vs Unsystematic RiskSystematic risk can be defined as a type of total risk that arises as a result of various external factors such as political factors, economic factors, and sociological factors. Systematic risk is non-diversifiable in nature. This means that this type of total risk cannot be controlled or minimized or avoided by the management of an organization. A systematic risk has the tendency to disrupt not just the whole of the market but an economy too. The major sources of systematic risk are risks related to the market, purchasing power, and interest rate and the common examples of such type of risk are inflation, price movements, fluctuation in interest rates, rise in unemployment, etc. On the other hand, unsystematic risk can be defined as a type of total risk that arises as a result of various internal factors taking place within an organization. Unsystematic risks are diversifiable in nature. This means that these types of risks can be controlled, minimized and even avoided by the management of an organization. Unsystematic risk has the tendency to disrupt the well being of an organization and sometimes the industry too. The major sources of such risks are risks pertaining to finances, business, and insolvency and the common examples of the same are a higher rate of operational costs, a rise in labor turnover, etc. Head to Head Comparison Between Systematic Risk vs Unsystematic Risk(Infographics)Below are the Top 9 comparison between Systematic Risk vs Unsystematic Risk: Key Differences Between Systematic Risk vs Unsystematic RiskThe key differences between systematic risk vs unsystematic risk are as follows:
Risk vs Unsystematic Risk Comparision TableGiven below are the Major Difference between systematic risk vs unsystematic risk:
ConclusionTotal risk comprises two types of risks that include risk- systematic risk and unsystematic risk. The Systematic risk is broader in comparison to the unsystematic risk. Systematic risk is a result of various external or macro-economic factors like political, social, and economic whereas unsystematic risk is a result of factors that are internal or microeconomic in nature. Systematic risks are uncontrollable while unsystematic risks can be easily controlled and taken care of with proper implementation of required strategies. Systematic risk cannot be minimized or eliminated whereas unsystematic risk can be minimized or eliminated. Recommended ArticlesThis is a guide to Systematic Risk vs Unsystematic Risk. Here we discuss the difference between Systematic Risk vs Unsystematic Risk, along with key differences, infographics, & a comparison table. You can also go through our other related articles to learn more– |