Meaning Of Systematic Risk
Systematic risk refers to type of risk inherent in whole market or market segment and affects the economy as a whole. This risk, in terms of finance, can be defined as risk of collapse for entire financial market as opposed to the risk associated only with individual entity, component or a group of system. Systematic risk cannot be diversified away and therefore also termed as “undiversifiable risk”, “volatility risk” or “market risk” influencing the total market instead of just a particular industry or stock. It is part of total risk occurring due to factors that are beyond the control of individual or a specific company such as economic, social and political factors. Systematic risk is external to organization and affects all of the investment and securities. In simple terms, it is pervasive, eternal and far-reaching market risk that brings in variety of troubling factors.
Systematic risk is both unpredictable and unavoidable in nature. This cannot be mitigated via diversification but can be through hedging or a correct strategy of asset allocation. Systematic risk is quite dangerous to the financial markets and economy of nation as it brings in heavy losses for companies as well as individuals. Although systematic risk cannot be predicted or completely avoided, but investors can manage it to some extent by ensuring that their portfolios comprise of asset classes like cash, fixed income and real estate, such that each of them will react differently to an overall market event. For instance, a rise in interest rates will result in making new -issue bonds more valuable, while causing some of the company’s stock value to diminish.
Types of Systematic Risk
Various types of systematic risk are as follows: –
Interest Rate Risk
The interest rate risk arises out of variations in market rates of interest. This primarily affects fixed income securities such as bonds in stock market as bond prices are inversely related with market interest rate. Interest rate risk, in fact, is composed of two opposite components: Price risk and Reinvestment risk. These two works in opposite direction to one another. Price risk is concerned with variations in the security prices arising out of variations in rate of interest.
Reinvestment risk, on other hand, is related to reinvesting dividend/interest income. A reinvestment risk will be positive (earnings on reinvested money would increase) when the price risk is negative (downfall in prices). Overall, the main source of risk to fixed income securities such as debentures and bonds is changes in interest rates.
Marker risk occurs due to changes in market price of securities, bringing a significant fall in the event of stock market correction. It is the result of general tendency of investors to follow market direction. This herd mentality of investors brings in market risk under which the prices of securities move together. In case, if market is not performing well and declining then even the shares prices of good performing companies will fall down.
Almost two-third of total systematic risk is constituted by the market risk. Therefore, due to this reason systematic risk is sometimes referred to as market risk. The variations in market price are the most prominent source of risk in securities.
Exchange Rate Risk
The exchange rate risk arises out of changes in the value of foreign currencies and thereby affects more companies with substantial exposure to foreign exchange transactions. In today’s globalized economy, most of the companies deals in foreign currency for completing their import and export transactions. There is always uncertainty associated with variations in the value of foreign currencies.
Therefore, this type of risk only affects the securities of those companies which deals in foreign exchange transactions. For example, it is more related to Multinational corporations who uses imported raw materials or products.
Purchasing Power Risk
Purchasing power risk, also known as inflation risk arises due to decrease in the purchasing power of money. Inflation is the continuous rise in general price levels that erodes the purchasing power of money, i.e., same amount of money will buy less goods/services due to rise in prices. This way if investor income does not increase at times of rising inflation, then the investor is in actual getting lesser income in real terms.
Purchasing power risk, similar to interest rate risk, also affects mainly the securities with fixed income as income from such securities remain fixed in nominal terms. It is also said that equity shares serve as good hedges against inflation and therefore, are subject to lower purchasing power risk.
Political risk is one that occurs primarily due to political instability in a nation or region. For example, if companies or business is operating in country that is at war, then such companies are considered at high risk. When a country is declaring war, then it would result in withdrawal of foreign funds thereby bringing in huge amount of risk for operating companies.
Benefits of Analysing Systematic Risk
The benefits of analysing a systematic risk are as discussed below: –
Systematic risk covers the entire economy and therefore, the person analysing it would get complete picture of overall economy. This would serve as a proxy for risk associated with whole economy instead of finding out the risk inherent in each sector.
Helps in understanding the Non-systematic risk
The investors by understanding the systematic risk affecting economy would get an idea that to what extend his/her portfolio is being exposed to non-diversifiable risk in economy. They will get good understanding of volatility that is going to cause in portfolio due to impact of any such event affecting the market as a whole.
Helps in identification of risk
Risk diversification form the basis of insurance and also that of investment. The presence of systematic risk, however at the same time, affects everything. Undertaking a problematic approach of its impact on risk profiling of insurance companies’ portfolios, will assist in understanding and identifying the risk in better way. Although a systematic risk cannot be reduced via diversification, it comes a long way to understand and identify risk.
Helps in understanding the repercussions
Systematic risk helps in understanding the repercussions and interlinkage as it affects the entire economy. For instance, systematic risk becomes a nationwide phenomenon when housing mortgage burst in 2007. The financial markets got affected by this liquidity crunch that affected other economies as well thereby leading to steep fall in trade and investment on global level.
Disadvantages of Systematic Risk
The disadvantages of systematic risk are as follows: –
These types of risk have wider impact and affects everyone unlike the sector-specific risks. For instance, businesses may slow down, jobs may cut and reduction in capital inflow. Therefore, these risks affect the overall economy and may result in global slowdown, if in case downside spreads to other countries as well.
Difficulty in studying sector-specific Risk
Systematic risk takes into consideration the entire economy that makes it difficult to analyse impact on distinct stocks, sector and businesses in isolated manner. There may be risks and factors impacting these businesses that are sector specific. In order to gather better understanding on them, it becomes crucial to study them in isolation instead of considering the holistic view.
Scale of impact may be different
Although systematic risk is non-diversifiable risk that impacts whole economy, but the scale of impact differs from one business to another and from one sector to other. Therefore, it becomes crucial to understand and study these sectors with a view different from entire economy.
Systematic Risk vs Unsystematic Risk
Both systematic and unsystematic risk are distinct from each other. The key differences among these two are explained in points given below: –
Meaning: Systematic risk denotes the profitability or loss linked with whole market segment such as changes in government policy for particular industry. Unsystematic risk, on the other hand, refers to risks associated with specific industry such as labour strike.
Nature: Systematic risk takes place due to uncontrollable factors like natural calamities instead of unsystematic risk-taking place out of factors that are controllable in nature such as production of non-demandable products.
Factors: The macroeconomic factors such as economic, social and political are the one that causes systematic risk. Unsystematic risk, on other hand, take place due to micro-economic factors such as labour strikes.
Categories: Systematic risk is divided into 3 categories such as market risk, purchasing power risk and interest risk. Whereas, unsystematic risk in categorized into business and financial risks.
Protection: An eradication of systematic risk can be done via ways such as hedging or asset allocation. Unsystematic risk, however, can be avoided via diversification of portfolio.
Example of Systematic Risk
The 2008 great recession sets out key example for systematic risk. All kinds of investments done in distinct securities by people saw a downfall in value of their investments due to market-wide economic event. Different kinds of securities got affected in diverse ways because of the great recession. Therefore, the investors holding stocks were affected in adverse ways as compared with one having wider allocation of assets.
Few of the examples of systematic risk are: Changes to law, Natural disasters, Currency value changes, Tax reforms, Economic recession, Changes in currency values, Political instability, Changes to law, Failure of banks and Flight of capital.
In financial management, avoidance of systematic risk is very difficult. The external factors are the one involved in causing systematic risk and these factors are both uncontrollable and unavoidable. Also, they influence the overall market in general but can be constraint to some extent only via hedging and asset allocation.