Unsystematic risk

Examples of Unsystematic risk in the following topics:

• Impact of Diversification on Risk and Return: Unsystematic Risk

  • In general, diversification can reduce risk without negatively impacting expected return.
  • In finance, systematic risk is the term associated with risk that can be diversified away by investing in a broader pool of assets.
  • The idea is that you can only diversify away so much risk, that the marginal returns on each new asset are decreasing, and each transaction has a cost in terms of a transaction fee and also research costs.
  • The risk that can be diversified away is called "unsystematic risk" or "diversifiable risk. "
  • Their approach was to consider a population of 3,290 securities available for possible inclusion in a portfolio, and to consider the average risk over all possible randomly chosen n-asset portfolios with equal amounts held in each included asset, for various values of n.

• Expected Risk and Risk Premium

  • Overall riskiness of an asset is composed of its own individual risk (beta) along with its risk in relation to the market as a whole.
  • In the financial realm, two types of risk exist: systematic and unsystematic.
  • Systemic risk is the risk associated with an entire financial system or entire market.
  • On the other hand, unsystematic risk is risk to which only specific classes of securities or industries are vulnerable.
  • Because of this characteristic, investors are not rewarded for taking on unsystematic risk.

• Impact of Diversification on Risk and Return: Systematic Risk

  • As a result, the portion of risk that is unsystematic -- or risk that can be diversified away -- does not require additional compensation in terms of expected return.
  • This type of risk cannot be diversified away, and is referred to as systematic risk.
  • This is the portion of risk that pays the risk premium, because the risk associated with this particular segment of the market is more tightly linked to the risk of the market as a whole.
  • This risk is present regardless of the amount of diversification undertaken by an investor.
  • Diversification theory says that the only risk that earns a risk premium is that which can't be diversified away.

• Approaches to Assessing Risk

  • Since planned actions are subject to large cost and benefit risks, proper risk assessment and risk management for such actions are crucial to making them successful.
  • As risk carries so many different meanings, there are many formal methods used to assess or to "measure" risk.
  • In enterprise risk management, a risk is defined as a possible event or circumstance that can have negative influences on the enterprise in question.
  • In a financial institution, enterprise risk management is normally thought of as the combination of credit risk, interest rate risk or asset liability management, market risk, and operational risk.
  • In project management, risk management can include: planning how risk will be managed, assigning a risk officer, maintaining a database of live risks, and preparing risk mitigation plans.

• Information and Risk Trade-Off

  • IT risk relates to the business risk associated with the use, ownership, operation, involvement, and adoption of IT within an enterprise.
  • Risk is the product of the likelihood of an occurrence times its impact (Risk = Likelihood x Impact).
  • IT risk management can be viewed as a component of a wider enterprise risk management (ERM) system.
  • IT risk transverses all four of the aforementioned categories and should be managed within the framework of enterprise risk management.
  • Risk appetite and risk sensitivity of the whole enterprise should guide the IT risk management process.

• Commercial Banks

  • Risk management (i.e. foreign exchange risks, interest rates, hedging commodities, derivatives)
  • Credit Risk – Risk that a borrower may not return the entirety of the payment owed.
  • Liquidity Risk – Risk that an acquired asset cannot be traded quickly enough to capture profit.
  • Market Risk – Virtually any capital asset has a market, and is therefore subjected to the risks of it's respective market.
  • Operational Risk – Risk that an operational issue will diminish returns.

• Reinvestment Risk

  • Reinvestment risk is the risk that a bond is repaid early, and an investor has to find a new place to invest with the risk of lower returns.
  • Reinvestment risk is one of the main genres of financial risk.
  • Reinvestment risk is more likely when interest rates are declining.
  • Pension funds are also subject to reinvestment risk.
  • Two factors that have a bearing on the degree of reinvestment risk are:

• Types of Risk

  • Prepayment risk is the risk that the buyer goes ahead and pays off the mortgage.
  • Credit risk or default risk, is the risk that a borrower will default (or stop making payments).
  • Liquidity risk is the risk that an asset or security cannot be converted into cash in a timely manner.
  • Operational risk is another type of risk that deals with the operations of a particular business.
  • Foreign investment risk involves the risk associated with investments in foreign markets.

• Comparing Price Risk and Reinvestment Risk

  • Price risk is positively correlated to changes in interest rates, while reinvestment risk is inversely correlated.
  • Price risk and reinvestment risk both represent the uncertainty associated with the effects of changes in market interest rates.
  • So there is little reinvestment risk.
  • There is, accordingly, more reinvestment risk.
  • In summary, price risk and reinvestment risk are two main financial risks resulting from changes in interest rates.

• Making Decisions Under Conditions of Risk and Uncertainty

  • Types of risk include:
  • Strategic risks: These are risks that arise from the investments an organization makes to pursue its mission and objectives.
  • Operational risks: These risks can arise due to choices about design and use of processes to create and deliver goods and services.
  • Other risks: Risks are very commonly associated with force majeure, or events beyond the control of the organization.
  • This can be mathematically daunting for many types of risk, especially financial risk.