What is Systematic Risk?
Systematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk.”
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Types of Systematic Risk
The various types are listed down as under
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- Interest-Rate Risk: It refers to the risk arising out of the change of market interest rates and affects fixed income instruments like bond
- Market Risk: It refers to risk arising out of changes in the market price of securities which causes a significant fall in the event of a stock market correctionMarket CorrectionMarket Correction is usually referred to as a fall of 10% or more from its latest high. It happens due to various reasons such as declining macro-economic factors, intense pessimism across the economy, securities specific factors, over-inflation in the markets, and so on.read more
- Exchange Rate Risk: It arises out of changes in the value of currencies and affects corporations with substantial foreign exchange transaction exposure
- Political Risk: It is mainly due to political instability in any economy, and it affects business decisions
Systematic Risk Example
Examples of systematic risk that would affect the whole economy as described under the various types are illustrated with the example as under.
- Interest Rate Risk: Government reducing/increasing interest rates which would affect the valuation of Securities.
- Market Risk: A stock market correction would wipe out wealth created by fund managers and affects the whole company.
- Exchange Rate Risk: A devaluation of other country’s currencies would make imports costlier.
- Political Risk: A country declaring war would lead to withdraw of foreign funds.
How is Analyzing Systematic Risk Useful?
#1 – Holistic View
This would go on to consider the entire economy, and the analyst would get a better picture as this provides a holistic view of the whole economy. It would serve as a proxy for the risk of the whole economy than having to find out the risk inherent in each sector in isolation
#2 – Helps Understanding Non-Diversifiable Risk
It is through having an understanding of the systematic risk that would affect the economy; the investor would tend to get an idea of the extent of his portfolio being exposed to non-diversifiable risk in the economy. By doing so, he/she would have a good feel or understanding for the volatility that would be caused in the portfolio because of an impact of any such event that would affect the market as a whole
#3 – Helps in Risk Identification
Risk diversification goes on to form the basis of insurance and also that of investment. The presence of systematic risk goes on to affect everything at the same time. By undertaking a probabilistic approach of its impact on the risk profiling of the portfolio of the insurance companies, this approach helps to understand and identify risks better. Though systematic risk cannot be reduced by diversification, it does come a long way in having to understand and identify risks
#4 – Helps in Understanding Repercussions
Since systematic risk affects the entire economy, it helps one understand the interlinkage and repercussions. For example, when the housing mortgage burst in 2007, the systematic risk which entangled there became a nationwide phenomenon, and this liquidity crunch affected the financial marketsFinancial MarketsThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more, which in turn affected other economies and led to a steep fall in trade and investment on a global basis.
Disadvantages
#1 – Mass Impact
Unlike sector-specific risk, such kind of risks affects everyone. Businesses may slow down, the capital inflow may reduce, and job cuts may be undertaken. Hence such risks affect the entire economy and may lead to a global slowdown if the downside spreads to other countries too
#2 – Difficult to Study Sector-Specific Risk
It considers the whole of the economy; it would be really difficult to consider the impact of the same on various sectors, stocks, and business in an isolated manner. There may be sector-specific risks and factors that go on to impact these businesses, and to have a greater understanding of the same; it becomes essential to study them in isolation than considering the holistic view
#3 – Scale of impact may be Different
Though non-diversifiable risk being systematic risk impacts the whole of the economy, the scale of impact may differ across the business and also among sectors. Here it becomes essential to understand and study these sectors with a view different from that of the entire economy
Limitations
- Although systematic risk impacts the entire economy, the scale and magnitude of the same may differ across sectors, and thus it becomes crucial to study them in isolation. Systematic risk itself may not give a complete picture to the analyst in such a scenario. He/she may need to analyze sector-specific behavior and factors that affect the same.
Conclusion
- Systematic risk being non-diversifiable, impacts all sectors, stocks, business, etc. and, in essence, the entire economy. It helps one to gauge the exposure by considering a holistic view of the risks inherentRisks InherentInherent Risk is the probability of a defect in the financial statement due to error, omission or misstatement identified during a financial audit. Such a risk arises because of certain factors which are beyond the internal control of the organization.read more in the economy.
- Such risk is dangerous to the economy as the same, when rampant, may be an indication of a slowing economy, sluggish business warning of an impending recession. It has a wide-scale impact and repercussions often spreading from one sector to another or even from one economy to that of another for that matter, when they are interlinked.
- However, to gauge and understand the risk inherent in any specific business or sector, one needs to study them in isolation, and systematic risk may not be able to help much in this regard.
- Nevertheless, it does come a long way in helping one understand the exposure and the massive hit the portfolio can take on in the event brought about by systematic or non-diversifiable risk and thus becomes an essential tool for risk management. It has also served as the base for various valuation models like the Capital Asset Pricing ModelCapital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more (CAPM).
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