Systematic risk
Encyclopedia
In finance
, systematic risk, sometimes called market risk
, aggregate risk, or undiversifiable risk, is the risk
associated with aggregate market
returns.
By contrast, unsystematic risk, sometimes called specific risk, idiosyncratic risk, residual risk, or diversifiable risk, is the company-specific or industry-specific risk in a portfolio
, which is uncorrelated with aggregate market returns.
Unsystematic risk can be mitigated through diversification
, and systematic risk can not be.
Systematic risk should not be confused with systemic risk
, the risk of loss from some catastrophic event that collapses the entire financial system
.
in 10 biotechnology companies. If unforeseen events cause a catastrophic setback and one or two companies' stock prices drop, the investor incurs a loss. On the other hand, an investor who purchases $100,000 in a single biotechnology company would incur ten times the loss from such an event. The second investor's portfolio has more unsystematic risk than the diversified portfolio. Finally, if the setback were to affect the entire industry instead, the investors would incur similar losses, due to systematic risk.
Systematic risk is essentially dependent on macroeconomic factors such as inflation, interest rates and so on. It may also derive from the structure and dynamics of the market.
In the capital asset pricing model
, the rate of return required for an asset in market equilibrium depends on the systematic risk associated with returns on the asset, that is, on the covariance
of the returns on the asset and the aggregate returns to the market.
Lenders to small numbers of borrowers (or kinds of borrowers) face unsystematic risk of default. Their loss due to default is credit risk
, the unsystematic portion of which is concentration risk
.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, systematic risk, sometimes called market risk
Market risk
Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...
, aggregate risk, or undiversifiable risk, is the risk
Financial risk
Financial risk an umbrella term for multiple types of risk associated with financing, including financial transactions that include company loans in risk of default. Risk is a term often used to imply downside risk, meaning the uncertainty of a return and the potential for financial loss...
associated with aggregate market
Financial market
In economics, a financial market is a mechanism that allows people and entities to buy and sell financial securities , commodities , and other fungible items of value at low transaction costs and at prices that reflect supply and demand.Both general markets and...
returns.
By contrast, unsystematic risk, sometimes called specific risk, idiosyncratic risk, residual risk, or diversifiable risk, is the company-specific or industry-specific risk in a portfolio
Portfolio (finance)
Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund, financial institution or individual.-Definition:The term portfolio refers to any collection of financial assets such as stocks, bonds and cash...
, which is uncorrelated with aggregate market returns.
Unsystematic risk can be mitigated through diversification
Diversification (finance)
In finance, diversification means reducing risk by investing in a variety of assets. If the asset values do not move up and down in perfect synchrony, a diversified portfolio will have less risk than the weighted average risk of its constituent assets, and often less risk than the least risky of...
, and systematic risk can not be.
Systematic risk should not be confused with systemic risk
Systemic risk
In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...
, the risk of loss from some catastrophic event that collapses the entire financial system
Financial system
In finance, the financial system is the system that allows the transfer of money between savers and borrowers. A financial system can operate on a global, regional or firm specific level...
.
Example
For example, consider an individual investor who purchases $10,000 of stockStock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
in 10 biotechnology companies. If unforeseen events cause a catastrophic setback and one or two companies' stock prices drop, the investor incurs a loss. On the other hand, an investor who purchases $100,000 in a single biotechnology company would incur ten times the loss from such an event. The second investor's portfolio has more unsystematic risk than the diversified portfolio. Finally, if the setback were to affect the entire industry instead, the investors would incur similar losses, due to systematic risk.
Systematic risk is essentially dependent on macroeconomic factors such as inflation, interest rates and so on. It may also derive from the structure and dynamics of the market.
Systematic risk and portfolio management
Given diversified holdings of assets, an investor's exposure to unsystematic risk from any particular asset is small and uncorrelated with the rest of the portfolio. Hence, the contribution of unsystematic risk to the riskiness of the portfolio as a whole may become negligible.In the capital asset pricing model
Capital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
, the rate of return required for an asset in market equilibrium depends on the systematic risk associated with returns on the asset, that is, on the covariance
Covariance
In probability theory and statistics, covariance is a measure of how much two variables change together. Variance is a special case of the covariance when the two variables are identical.- Definition :...
of the returns on the asset and the aggregate returns to the market.
Lenders to small numbers of borrowers (or kinds of borrowers) face unsystematic risk of default. Their loss due to default is credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
, the unsystematic portion of which is concentration risk
Concentration risk
Concentration risk is a banking term denoting the overall spread of a bank's outstanding accounts over the number or variety of debtors to whom the bank has lent money. This risk is calculated using a "concentration ratio" which explains what percentage of the outstanding accounts each bank loan...
.
See also
- Systemic riskSystemic riskIn finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...
- Modern portfolio theoryModern portfolio theoryModern portfolio theory is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets...
- Capital asset pricing modelCapital asset pricing modelIn finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
- Risk modelingRisk modelingFor risk modeling in general see risk modelingFinancial risk modeling refers to the use of formal econometric techniques to determine the aggregate risk in a financial portfolio...
- Taleb distributionTaleb DistributionIn economics and finance, a Taleb distribution is a term coined by U.K. economists/journalists Martin Wolf and John Kay to describe a returns profile that appears at times deceptively low-risk with steady returns, but experiences periodically catastrophic drawdowns. It does not describe a...