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; 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 as under:

  • Interest-Rate Risk: It refers to the risk arising from the change of market interest rates and affects fixed income instruments like bonds.Market Risk: It refers to risk arising out of changes in the market price of securities that cause a significant fall in the event of a stock market correction Market 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 moreExchange Rate Risk: It appears out of changes in the value of currencies and affects corporations with substantial foreign exchange transaction exposurePolitical Risk: It is mainly due to political instability in any economy. It involves business decisions.

Systematic Risk Example

Examples of systematic risk that would affect the whole economy as described under the various types are illustrated in the example below.

  • Interest Rate Risk: Government reducing/increasing interest rates would affect securities valuation.Market Risk:Market Risk:Market risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk.read more A stock market correction would wipe out wealth created by fund managers and affect the whole company.Exchange Rate Risk: A devaluation of other countries’ currencies would make imports costlier.Political Risk:Political Risk:Political risk is defined as a risk that emerges as a result of a change in a country’s governing body, posing a risk to investors in financial instruments such as debt funds, mutual funds, and equities.read more A government declaring war would lead to the withdrawal of foreign funds.

How is Analyzing Systematic Risk Useful?

#1 – Holistic View

It would 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 entire economy rather than having to find out the risk inherent in each sector in isolation.

#2 – Helps Understanding Non-Diversifiable Risk

#3 – Helps in Risk Identification

#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 mortgageMortgageA mortgage loan is an agreement that gives the lender the right to forfeit the mortgaged property or assets in case of failure to repay the borrowed sum and interest.read more burst in 2007, the systematic risk became a nationwide phenomenon. This liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more 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 affected other economies and led to a steep fall in trade and investmentInvestmentInvestments are typically assets bought at present with the expectation of higher returns in the future. Its consumption is foregone now for benefits that investors can reap from it later.read more globally.

Disadvantages

#1 – Mass Impact

Unlike sector-specific risks, such kinds of risks affect everyone. For example, businesses may slow down, the capital inflow may reduce, and job cuts. Hence such risks affect the entire economy and may lead to a global slowdown if the downside spreadsSpreadsSpread is the price, interest rate, or yield differentials of stocks, bonds, futures contracts, options, and currency pairs of related quantities.read more to other countries.

#2 – Difficult to Study Sector-Specific Risk

It considers the whole of the economy. It would be difficult to assess the impact on various sectors, stocks, and businesses in an isolated manner. There may be sector-specific risks and factors that impact these businesses. Studying them in isolation rather than considering the holistic view is essential to understand the same better.

#3 – Scale of impact may be Different

Though the non-diversifiable risk is a systematic risk that impacts the whole economy, the scale of impact may differ across the business and 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. The systematic risk may not give the analyst a complete picture in such a scenario. They may need to analyze sector-specific behavior and factors that affect the same.

Conclusion

  • Systematic risk being non-diversifiable, impacts all sectors, stocks, businesses, etc., and, in essence, the entire economy. It helps one gauge the exposure by considering a holistic view of the risks inherent Risks 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 Economy An economy comprises individuals, commercial entities, and the government involved in the production, distribution, exchange, and consumption of products and services in a society.read moreas the same, when rampant, may indicate 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 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 in the event brought about by systematic or non-diversifiable risk. Thus, it 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).

This article is a guide to Systematic Risk Definition. We discussed the top 4 types, a systematic risk example along with advantages, and disadvantages. You can learn more about excel modeling from the following articles: –

  • Diversifiable RiskInflation Risk DefinitionEvent RiskBond Risks Definition