The risks and rewards that come with particular investments are determined by market structures and events and being aware of these risks can help you build stronger investment portfolios.
Systematic risk is one type of economic risk that has the potential to negatively impact assets and investments in almost any sector.
What is Systematic Risk?
Systematic risk, also known as market risk is the portion of total risk that is caused by factors beyond the control of a specific sector or stock. It arose due to external factors of that organizer and cannot be diversified.
All investments or securities are related to systematic risk and cannot be eliminated the risk by holding a large number of securities. Systematic risk occurs due to several reasons like war, natural disaster, Inflation, currency rate fluctuations, and other macroeconomic factors.
Real-Life Example of Systematic Risk - Covid-19
A recent example is the pandemic which is the most scary. The COVID-19 pandemic spread worldwide, affecting not only the health of humans but also causing significant disruptions to economies, industries, and investments.
When the COVID-19 pandemic struck, nations implemented lockdowns, businesses ceased operations, and individuals remained indoors. This set off a chain reaction. Airlines suspended flights, manufacturing plants halted production, and financial markets experienced a downturn.
This cascading impact exemplifies the concept of systematic risk - where one incident sets off a series of repercussions that affect various aspects of society.
Difference Between Systematic Risk and Unsystematic Risk
The basic differences between systematic risk and unsystematic risk are discussed below.
- Systematic risk affects the entire market or the segment, while unsystematic risk refers to a specific industry, sector, or company.
- Systematic risk occurs due to uncontrollable external factors. Unsystematic risk arises due to internal factors and can be controlled.
- Systematic risk cannot be diverged through diversification, while unsystematic risk can be decreased or eliminated through diversification.
- Systematic risk measured by beta coefficient. Unsystematic risk measured by alpha coefficient.
- Systematic risk includes Inflation, recession, or interest rate risk. Unsystematic risk includes management issues or product recalls.
Types of Systematic Risk
Systematic risk is divided into four types viz interest rate risk, market risk, purchasing power risk, and exchange rate risk.
1. Interest Rate Risk
Interest rate risk is a type of systematic risk that directly impacts debt securities like bonds and debentures. Interest rate risk is the cause of a change in the market interest rate.
When the market interest rate rises related to the coupon interest rate, the market price of the bond decreases. Likewise, the market price of the bond rises when drop in the market interest rate compared to the bond rate.
The variation of bond prices results in variation in interest rates is known as interest rate risk.
2. Market Risk
Market risk is a type of systematic risk that affects shares. The market price of shares moves upward or downward for some time. The short-term volatility arises in the stock market due to changes in investor expectations.
These fluctuations cause variations in the return on equity, which is called market risk. Market risk is usually accounted for about two-thirds of total systematic risk.
3. Purchasing Power Risk
Purchasing power risk, also known as Inflation Risk results in erosion of the purchasing power of money. If Inflation occurs in the economy, the price of goods and services will rise. As a result, the investor experiences a drop in purchasing power of his investment and return from the investment.
This is called purchasing power risk and it directly impacts all securities in the market.
4. Exchange Rate Risk
In the economy, most of the companies deal with foreign currency. Exchange rate risk is uncertainty in the change in the value of the foreign currency. It only affects companies with foreign exchange transactions such as the export and import of raw materials.
How can investors manage Systematic Risk?
Systematic risk is uncontrollable and unpredictable. An investor only can manage their portfolio by investing in different asset classes such as equity, debt, real estate, etc.
However such asset classes will affect any unexpected event as the overall market is affected. For example, if the central bank of an economy hikes the interest rates, it will make newly issued bonds more attractive. Hence, a well-diversified portfolio can minimize the losses of an investor.
How is Systematic Risk Measured?
The systematic risk of a security is measured by a statistical measure known as Beta, which is required for the calculation of beta is the historical data of returns of the individual security and the return of a broader market (S&P 500).
One method used for the calculation of Beta is called the correlation method.
A stock or portfolio's beta value indicates how volatile the asset is about the volatility of the market as a whole. It can be used to proxy a stock's systematic risk about market risk and serves as a stand-in for the systematic risk of the stock. The following meaning can be given to a portfolio's β value when it is utilized as a stand-in for measuring systematic risk.
Where,
rim = correlation coefficient between the returns of stock i and the returns of the market index
σi = standard deviation of returns of stock i
σm = standard deviation of returns of the market index
σm² = variance of the market returns
When β = 0 it suggests the portfolio/stock is uncorrelated with the market return.
When β < 0 it suggests the portfolio/stock has an inverse correlation with the market return.
When 0 < β < 1 it suggests the portfolio/stock return is positively correlated with the market return however with smaller volatility.
When β = 1 it suggests that the portfolio return has a perfect correlation with the market portfolio return.
When β > 1 it suggests that the portfolio has a positive correlation with the market, but would have price movements of greater magnitude.
The Bottom Line
Systematic risk is the variability in security returns due to changes in the economy or the market. All stocks and sectors are affected by such circumstances. Systematic risk can arise from Inflation, war, natural disasters, and any macroeconomic factors.
Systematic risk can be minimized through diversification and also affects the overall market or economy. Hence, investors must be aware of such economic events and make the best investment decisions with a good diversification and risk appetite.
Post a Comment