Question

Risk can be subdivided into systematic and unsystematic risk. Describe each type of risk, the related compensation for bearing that risk, and give some examples of each type.

Answer 1

Total risk is comprised of market risk plus diversifiable risk. Total risk of portfolio in statistical terminology is stated as standard deviation of the asset.

Total risk = Market risk (Systematic risk) + Diversifiable risk (Unsystematic risl)

Total risk is the overall risk which an asset carries. It is very nature of the any asset to have it carries risk. All assets carry some amount of risk and even to a certain level risk free asset is theoretical because in global political scenario a government can default on its own currency though this is very unlikely but there is some probability of happening of such extreme events hence total risk of an asset covers every possible risk which an asset holds.

Market risk is the risk which uncontrollable risk which emerges due to market scenarios. Market scenarios keep on changing and brings risk and reward for holders. Investors earn return for taking market risk. This risk is also called systematic risk. Systematic risk is measured by beta for calculating theoretical return on the asset through CAPM equation. Market risk is unavoidable risk and investor has to carry this for holding particular asset. However, the market risk differs for each asset class.

Diversifiable risk is the risk which can be diversified or eliminated by adding different type of assets having low correlation to each other. Diversifiable risk is also called unsystematic risk. Diversification can eliminate the unsystematic risk of the portfolio however, it won’t eliminate market risk. Diversification is achieved through selecting stocks which have low correlation with existing portfolio. The low correlation means that stock to be added in portfolio will not have same risk profile as existing. Stock with low correlation in existing portfolio will achieve true diversification hence, diversification reduces the risk of the portfolio of an investor. Investors get compensated for taking this specific risk.

Examples of Systematic risk: Interest rate risk, Price risk, Currency risk, Natural calamities and other types of financial crisis

Examples of Unsystematic risk: Risk specific to business, business risk, competition, labor strikes, regulation for particular business and risk related to particular business.