systematic risks

(noun)

In finance and economics, systematic risk (sometimes called aggregate risk, market risk, or undiversifiable risk) is vulnerability to events which affect aggregate outcomes such as broad market returns, total economy-wide resource holdings, or aggregate income.

Examples of systematic risks in the following topics:

  • The Capital Asset Pricing Model

    • It determines what the rate of return of an asset will be, assuming it is to be added to an already well-diversified portfolio, given that asset's systematic risk.
    • Systematic risk - also called market risk or non-diversifiable risk - represents the risk present in a security in relation to the economy as a whole.
    • Unsystematic risk - also called idiosyncratic risk or diversifiable risk - represents the risk present in a security that is specific to that investment and unrelated to the overall risk of the market .
    • CAPM states that in market equilibrium, investors are only rewarded for bearing systematic risk - the type of risk that cannot be diversiļ¬ed away.
    • However, it is impossible to remove systematic risk, as it concerns the economy in general.

  • Impact of Diversification on Risk and Return: Systematic Risk

    • Systematic risk is intrinsic to the market, and thusly diversification has no effect on its presence in investments.
    • 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.
    • Diversification theory says that the only risk that earns a risk premium is that which can't be diversified away.

  • 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.
    • Systematic risk can be understood further using the measure of Beta.
    • The term risk premium refers to the amount by which an asset's expected rate of return exceeds the risk free rate.

  • Defining the Security Market Line

    • The security market line displays the expected rate of return of a security as a function of systematic, non-diversifiable risk.
    • The security market line graphs the systematic, non-diversifiable risk (stated in terms of beta) versus the return of the whole market at a particular time, and shows all risky marketable securities.
    • The Y-intercept of the SML is equal to the risk-free interest rate.
    • Recall that the risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss.
    • The slope of the SML is equal to the market risk premium and reflects the risk return trade off at a given time.

  • Inflation Premium

    • In addition, they will want to be compensated for the risks of the money having less purchasing power when the loan is repaid.
    • These risks are systematic risks, regulatory risks and inflationary risks.
    • The inflation premium will compensate for the third risk, so investors seek this premium to compensate for the erosion in the value of their capital, due to inflation.
    • Since the inflation rate over the course of a loan is not known initially, volatility in inflation represents a risk to both the lender and the borrower.

  • 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.

  • Measuring Risk

    • The higher the risk undertaken, the more ample the expected return and the lower the risk, the more modest the expected return.
    • In other words, the higher the risk undertaken, the more ample the return - and conversely, the lower the risk, the more modest the return.
    • This risk and return tradeoff is also known as the risk-return spectrum.
    • Risk is therefore something that must be compensated for, and the more risk the more compensation is required.
    • Beta is also referred to as financial elasticity or correlated relative volatility, and can be referred to as a measure of the sensitivity of the asset's returns to market returns, its non-diversifiable risk, its systematic risk, or market risk.

  • Risk and Return Considerations

    • The higher the risk undertaken, the more ample the expected return - and conversely, the lower the risk, the more modest the expected return.
    • In other words, the higher the risk undertaken, the more ample the return - and conversely, the lower the risk, the more modest the return.
    • This risk and return tradeoff is also known as the risk-return spectrum.
    • Risk is therefore something that must be compensated for, and the more risk the more compensation is required.
    • Beta is also referred to as financial elasticity or correlated relative volatility, and can be referred to as a measure of the sensitivity of the asset's returns to market returns, its non-diversifiable risk, its systematic risk, or market risk.

  • Valuing the Corporation

    • Generally speaking, the discount rate or capitalization rate may be defined as the yield necessary to attract investors to a particular investment, given the risks associated with that investment.
    • The CAPM method derives the discount rate by adding a risk premium to the risk-free rate.
    • In this instance, however, the risk premium is derived by multiplying the equity risk premium times "beta," which is a measure of stock price volatility.
    • Beta is associated with the systematic risks of an investment.
    • CAPM Model ke = Rf + B ( Rm-Rf) + SCRP + CSRP Where: Rf = Risk free rate of return (Generally taken as 10-year Government Bond Yield) B = Beta Value (Sensitivity of the stock returns to market returns) Ke = Cost of Equity Rm= Market Rate of Return SCRP = Small Company Risk Premium, CSRP= Company specific Risk premium

  • Arbitrage Pricing Theory

    • where r is the return, a is a constant, each F is a systematic factor, each b is the sensitivity of the asset to the factor (factor loading), and epsilon is an error term that captures idiosyncratic random shocks (with a mean value of zero).
    • Naturally, this means that there are limits to how accurate APT is in the real world, but APT is still used as the basis for many of the commercial risk systems employed by asset managers.
    • APT can also be expressed in terms of expected returns where RP is the risk premium of the factor, and rf is the risk-free rate.