Systematic Risk and Unsystematic Risk

Systematic Risk and Unsystematic Risk. All investors must know the difference between systematic and unsystematic risk because it will help them to take effective investment decision making. In a broader sense, all types of risk can be categorized into two types; one is a systematic risk which is the non-diversifiable risk and the other is an unsystematic risk or non-systematic risk or diversifiable risk.

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Systematic Risk and Unsystematic Risk – Meaning and Components. Now, the detail discussions of systematic risk and unsystematic risk present as below:

Systematic risk

Systematic risk refers to that portion of the total variability in return on investment caused by factors affecting the prices of all securities in the portfolio. Economical, political, sociological changes are the sources of systematic risk. Their effect is to cause prices of nearly all individual common stocks, bonds, and other securities in the market to move together in the same manner. Systematic risk affects the economic or financial system.

Category of Systematic Risk

The systematic risk may be categorized under the following means:

Market risk:

The price of common stock changes frequently in the process of bought and sold by the investor or speculator in the market place. The price of a stock may fluctuate daily and cyclically even though earnings maintain unchanged and some common stocks have a seasonal pattern. Because of the changes in the market prices of the stock the investors can lose money. Variability in return on most common stocks that is due to basic sweeping changes in investor expectations is referred to as market risk. Expectations of lower corporate profits, in general, may cause the larger body of common stocks to fall in price.

Investment prices vary because investors vacillate in their preference for different forms of investments or simply because they sometimes have money to invest and sometimes do not have. The extensive vagaries of the stock market, the uncertainty and slowness of real estate markets and the irregular markets for mortgages and second-grand bond issues all illustrated in the presence of market risk.

Interest-rate-risk:

Interest-rate-risk may be defined as the fluctuation in the market price of fixed income securities owing to changes in levels of the interest rate. Fixed income securities mean notes and bonds, mortgage-loan and preferred stock paying a definite amount of interest or dividends annually to investors. Interest is the price paid for the use of money and like other prices fluctuates with demand and supply forces operating in the market. The degree of fluctuation in the market prices of fixed income securities resulting from interest-rate-risk depends firstly on the amount of change in interest rates. With any change in the market rate of return on a bond, the market price changes inversely. The second factor affecting the degree of fluctuation in the length of the period of maturity. Every business or price of the property is subject to the possibility that its earning power or usefulness may wane because of competition, change in demand, uncontrollable costs, managerial error, government action or some similar circumstances.

Liquidity risk:

Liquidity risk is the possibility of not being able to sell an asset for fair market value. When an investor acquires an asset, he expects that the investment will mature or hat it could be sold to someone else. In either case, the investor expects to be able to convert the security into cash and use the proceeds for current consumption or other investment. The more difficult it is to make this conversion, the greater the liquidity risk.

Default risk:

Another risk of systematic risk is default risk. This type of risk arises because firms may eventually go bankrupt. Default risk is undiversifiable or uncontrollable as it is systematically related to the business cycle affecting almost all investments even though some default risk may be diversified away in a portfolio of independent investments.

Real estate risk:

Such type of systematic risks is unique and generally not found in most investments rather than real estate. The specific risk inherited in real estate investments are given below:

As there is no continuous auction trading market, the quoted price may not represent the intrinsic value of the property.
It is more difficult to find a buyer and seller raising the cost of transacting.
Real estate markets are inefficient as they are likely to be segmented.
The cost of acquiring information is greater.
Property value is more influenced by changes in the rates of interest than other equities.
Returns on real estate assets are determined by the going rates on default-free assets.
Real estate is less liquid than financial instruments.

Unsystematic risk

Unsystematic risk – A portion of total risk that is unique or peculiar to a firm or an industry above and beyond that affecting the securities market, in general, may be termed as unsystematic risk. Management capability, consumer preference, labor strikes are the elements of unsystematic risk.

Components of The Unsystematic Risk

However, the unsystematic risk of investment consists of two major components:

credit risk and
sector risk.

Credit risk:

Credit risk sometimes called company risk consists of business risk and financial risk. Business risk is the risk inherent in the nature of the business. On the other hand, financial risk is the risk in addition to business risk arising from using financial leverage. Credit risk is associated with the ability of the firm that issues securities to meet its promise on those securities. The fundamental promise of every investment is a return commensurate with its risk. So the credit risk analyzed is the ability to deliver returns that are consistent with the risk assumed.

However, business risk and financial risk are discussed below:

Business risk:

The loss of income on capital associated with the ability of some companies to maintain their competitive position and to maintain their earnings growth is sometimes referred to as the business risk. Common stock and to some extent preferred stock and bond posses this risk. The risk that results is either temporary or permanent. The business risk is not only associated with the weaker companies that have suffered a total loss but also happened in the case of some quality companies when deficit earnings or sharp drop earnings sustained which have resulted in substantial losses to investors.

In other words, business risk is defined as the change that the firm will not have the ability to compete successfully with the assets that it purchases. As for example, the firm may acquire a machine that may not operate properly that may not produce salable products or that may face other operating or market difficulties that cause losses. Any operational problems are classed as a business risk.

Category of Business Risk

Business risk can be divided into two categories: external and internal.

Internal business risk is largely associated with the efficiency with which a firm conducts its operations within the broader operating environment imposed upon it.

On the other hand, external business risk is the result of operating conditions imposed upon the firms by circumstances beyond its control. Each firm faces its own set of external risk, depending upon the specific operating environment factors that it must deal with.

Financial risk:

Financial risk is associated with the way in which a company finances its investment activities. It may be defined as the change that an investment will not generate sufficient cash flows to cover interest payments on money borrowed to finance it or principal payments on the debtor to provide profits to the firm. We usually gauge financial risk by looking at the capital structure of a firm. The presence of borrowed money in the capital structure creates fixed payments in the form of interest that must be sustained by the firm. The financial risk is an avoidable risk to the extent that managements have the freedom to decide to borrow or not to borrow funds. A firm with no debt financing has no financial risk.

Sector risk:

Sector or industry risk refers to the risk of doing better or worse than expected as a result of investing in one sector of the economy instead of another. Sector investing implicitly acknowledges that the impact of individual investment decisions is less critical, certainly too large portfolios than investing in the proper sector at the proper time. Sector rotation is a portfolio management style-shifting resources to sectors that are expected to be more promising and are overweighted in a portfolio in contrast to other sectors which are underweighted.

As the number of stocks in the portfolio is increased, the unsystematic or residual risk of the individual securities is diversified away leaving only the systematic or market-related risk.

We assume that all rationale profit-maximizing investors want to hold a completely diversified market portfolio of the risky assets and they borrow or lend to arrive at a risk level that is consistent with their risk preferences. Under such conditions, the relevant risk measure for an individual asset is its co-movement with the market portfolio. This co-movement measured by an asset’s covariance with the market portfolio is its systematic risk.

Finally, we may draw a conclusion as- we can divide total risk into two components viz., a general or market component and a specific or issuer component. An investor can construct a diversified portfolio and eliminate part of the total risk called diversifiable or non-market risk. The systematic risk known as non-diversifiable or market risk is directly associated with overall movements in the general market or economy. Systematic Risk and Unsystematic Risk.

Categories of risk	Sources of risk
Pervasive risk	Purchasing power risk Exchange rate risk Political
Systematic risk	Market risk Interest rate risk Liquidity risk Default risk Real estate risk
Unsystematic risk	Credit risk Business risk Financial risk Sector risk

Different connotation of risk can be shown as under:

Total risk = General risk + Specific risk

= Systematic risk + Non-systematic risk

= Nondiversifiable risk + Diversifiable risk

= Market risk + Issuer risk

Systematic Risk and Unsystematic Risk

Systematic Risk and Unsystematic Risk – Meaning and Components