Question

Discuss systematic risk and unsystematic risk, and how they are measured. Is it possible to neutralize or lessen the effects of each of these risks? If yes, how can this be accomplished?

Answer 1

Systematic risk: Systematic risk is the risk that is caused by the factors that are beyond the control of the organization or company. It is because of external factors of the organization. This is the risk of the market and not individual entity. It impacts the entire industry. It is based on macro economic factors and cannot be diversified away. The examples of this type of risks are interest rate risk, market risk, inflation risk etc. It is a macro level risk

Unsystematic risk: Unsystematic risk is the company or industry specific risk. It arises because of the influence of the factors which are internal to the organization or company. This risk can be diversified away and is a micro risk. The examples of this type of risks are operational risk, liquidity risk, financial risk etc.

Measurements of risks:

Systematic risk is measured by Beta of the security. We need to calculate the beta of the security to measure the systematic risk. Beta can be calculated by the following CAPM equation:

Expected return of security = Risk free rate + Beta * Market risk premium

or it can also be calculated by:

Beta = Covariance of returns of security with market returns / Variance of market returns

On the other hand, unsystematic risk is measured by mitigation of systematic risk through diversification of the portfolio.

Diversification:

Systematic risk cannot be diversified away because it is inherent to the market and all the stocks. It is an undiversifiable risk. So it is not possible to neutralize or lessen the effects of systematic risk. While we can neutralize or lessen the effects of unsystematic risk through diversification. We can include the securities carrying different amounts of risks and returns in the portfolio to counter the risks created by them.