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 .

• 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.

• Government Failure

  • A government failure is not the failure of the government to enact a solution to a failure, but rather it is a systematic problem that prevents an efficient government solution to the problem.
  • Regulatory arbitrage occurs when a regulated institution takes advantage of the difference between its real risk and the regulatory position.
  • Regulatory risk is a risk faced by private sector firms when there is a chance that regulatory changes will negatively affect their business.

• Measuring and Managing Risk

  • Time is a component of risk for varying reasons; however, the two most common are related to the increase in general uncertainty rising with the time horizon and reinvestment risk.
  • Risk premium compensates holders for risks inherent to an investment and are incorporated in the rate of return quoted for an investment.
  • The differential in yield can be attributed to a risk premium for time to maturity.
  • Another aspect of time horizon is reinvestment risk.
  • To compensate investors for taking on this type of risk, the issuer will provide a risk premium to incentivize the investor to purchase the investment.

• Institutions, Markets, and Intermediaries

  • Through diversification of loan risk, financial intermediaries are able to mitigate risk through pooling of a variety of risk profiles and through creating loans of varying lengths from investor monies or demand deposits, these intermediaries are able to convert short-term liabilities to assets of varying maturities.
  • Additionally, through diversified lending practices, banks are able to lend monies to high-risk entities and by pooling with low-risk loans are able to gain in yield while implementing risk management.

• Asymmetric Information: Adverse Selection and Moral Hazard

  • For example, if a bank set one price for all of its checking account customers it runs the risk of being adversely affected by its low-balance and high activity customers.
  • A moral hazard is a situation where a party will take risks because the cost that could incur will not be felt by the party taking the risk .
  • In relation to asymmetric information, moral hazard may occur if one party is insulated from risk and has more information about its actions and intentions than the party paying for the negative consequences of the risk.
  • The driver will take risks because the cost is not directly felt due to a transaction.

• Behavioral Economics: Irrational Actions

  • Behavioral finance: the intent is to explain why market participants make systematic errors.

• Determinants of investment

  • Because all investments come with a certain amount of risk, the interest rate represents an opportunity cost.
  • The level of risk can be seen to a certain extent when analyzing the income and interest rates, which allows the risks to be managed.

• National Security Argument

  • National security protectionist arguments pertain to the risk of dependency upon other nations for economic sustainability.
  • This highlights a critical protectionist argument pertaining to the very real risk of dependency upon other nations for economic sustainability.
  • However, the opportunity cost of leveraging the ever-growing global markets make this an unattractive prospect if taken to any extreme, as the benefits of global trade rapidly offset the risk of economic dependency upon hostile nations.

• Unfair Competition Argument

  • This is also a risk when governments get too involved in business, a criticism often pointed out in China.
  • Another critical risk in the global market is intellectual property (IP) protection.
  • This reduces the desire for innovation and places large economic risks on countries dependent upon this for growth.
  • This is addressed through international standards and trade agreements, standardizing governmental policy on a global level to reduce the risk of monopoly and unfair consolidation towards market dominance.
  • This chart highlights the very real risk of lost economic value in a monopolistic situation (deadweight loss in yellow).