Question

Q9: What is the difference between un-systematic and systematic risk? Show graph! Give Examples.

Unsystematic Risk: Systematic Risk:

Graph:

--What type of risk can be diversified away? How would you do this? What statistical measures would you have to look at? Explain!

Answer 1

Systematic risk is the risk that is associated with the entire market while unsystematic risk is the risk that is associated with a particular industry or a particular security. Systematic risk is uncontrollable and hence is not diversifiable while unsystematic risk can be controlled and hence is diversifiable.

Examples of systematic risks are interest risk, market risk and purchasing power risk. Examples of unsystematic risk are business risk and financial risk.

The risk that can be diversified away is unsystematic risk. One can do this by diversifying the portfolio. For example suppose that you have a portfolio in which you have invested in stocks of auto industry companies and real estate companies. Both these companies are subjected to rise or fall in interest rates and so the stock prices will rise or fall depending on interest rate movements. To reduce the risk exposure you can add stocks from sectors that are not influenced by interest rate movements like the information technology companies, health care companies etc.

The statistical measure of systematic risk is “beta”. Beta measures the amount of systematic risk that an individual security has relative to the entire market.

The graph is provided below. The x axis shows the number of stocks in a portfolio and y axis shows the portfolio risk. Arrow AB is the total risk, arrow CD is the unsystematic risk and arrow EF is the systematic risk. The graph is attached in the image below: