Question

what is the difference between idiosyncratic and systemic risk? please give an example of each. which one can be eliminated through diversification? how do we measure a company's systemic risk?

Answer 1

1] Idiosyncratic risk [also called unsystematic risk], is the risk attached to a particular asset/security or a particular class of assets/securities. It does not apply to the whole market.

For instance, if there is a crisis in the oil industry, only securities of those firms, that are in the oil sector, would be affected.

Systematic risk [also called market risk], on the other hand, is the risk that affects all the assets/securities in the market, though to a different extent in each case.

A change in general economic condition will affect all the securities in the market-one instance can be the change in market interest rates.

2] Only idiosyncratic risk can be minimized through diversification. Systematic risk cannot be diversified away; hence needs to be compensated,

3] The systematic risk of a security can be measured by beta.

Beta is the relative measure of the movement of a security's return in relation to the market return over a period of time. It is given by the formula \:

SD of the returns of the security*Correlation of the returns of the security with the market return/SD of the market return.

The beta of the market is 1 and the betas of securities are multiples of 1.