systematic risk

Examples of systematic risk in the following topics:

• The Relationship Between Risk and Return and the Security Market Line

  • Investment assets are typically characterized as having two performance risks: systematic (or market risk) and non-systematic risk.
  • Systematic risk arises from market structure or dynamics, which produce shocks or uncertainty faced by all agents in the market.
  • Non-systematic risk is unique to a specific company and can be reduced through diversification.
  • In finance, the capital asset pricing model (CAPM) is used to determine the required rate of return of an asset, taking into account an asset's sensitivity to non-diversifiable or systematic risk.
  • For individual securities, the security market line (SML) and its relation to expected return and systematic risk (beta) depicts an individual security in relation to their security risk class .

• 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.

• The Value of Diversification

  • The risks that are inherent to a specific investment can be compensated for by a market-assessed risk premium, whereby market participants adjust the price of an asset, impacting its overall return, based on the risk characteristics of the asset.
  • It's important to note that diversification does not remove all of the risk from the portfolio.
  • Diversification can reduce the risk of any single asset, but there will still be systematic risk (or undiversifiable risk).
  • Systematic risk arises from market structure or dynamics which produce shocks or uncertainty faced by all agents in the market.
  • Systematic risk will affect the portfolio, regardless of how diversified it is.

• The Capital Asset Pricing Model

  • This model focuses on measuring a given asset's sensitivity to systematic risk (also referred to as market risk) in relation to the expected return compared to that of a theoretical risk-free asset.
  • All this really means is that the CAPM tries to measure the risk the market will offer the asset compared to the risk-free rate, and make sure the expected return will offset that risk.
  • Through rearranging these variables, you can also take a look at the concept of the security market line (SML), which underlines a security's relationship with systematic risk and respected return in a graphical format.
  • On the left side of the equation below, you have an assessment of the overall risk relative to a risk-free asset.
  • Calculate sensitivity to risk on a theoretical asset using the CAPM equation

• 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.

• 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.

• Factors External to the Firm

  • The weighted average cost of capital is vulnerable to market risks, interest rate changes, inflation, economic factors, and tax rates.
  • As markets rise and fall, the cost of capital as well as the perceived market risk (systematic risk) will naturally and relatively unpredictably fluctuate.
  • When utilizing markets as a source of funding, the intrinsic risk of the market itself is outside of the control of the organization.
  • The cost of capital is largely a simple trade off between the time value of money, risk, return, and opportunity cost.
  • Any external factors in the form of opportunity costs or unexpected risks can impact the overall cost of capital.

• 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.