Question

Discuss the difference between a stock’s systematic (market) risk and non-systematic (unique) risk?

Answer 1

There is always a risk incorporated in every investment like shares or debentures. The two major components of risk systematic risk and unsystematic risk, which when combined results in total risk.

The systematic risk is the hazard which is associated with the market or market segment as a whole. It arises due to macroeconomic factors of business such as social, political or economic factors. Such fluctuations are related to the changes in the return of the entire market. Systematic risk is caused by the changes in government policy, the act of nature such as natural disaster, changes in the nation’s economy, international economic components, etc.

It is a result of external and uncontrollable variables, which are not industry or security specific It affects the entire market leading to the fluctuation in prices of all the securities in the entire market.

Systematic Risk is divided into three categories, that are explained as under:

• Interest risk: Risk caused by the fluctuation in the rate or interest from time to time and affects interest-bearing securities like bonds and debentures.
• Inflation risk: Alternatively known as purchasing power risk as it adversely affects the purchasing power of an individual. Such risk arises due to a rise in the cost of production, the rise in wages, etc.
• Market risk: The risk influences the prices of a share, i.e. the prices will rise or fall consistently over a period along with other shares of the market.

Systematic risk cannot be eliminated by diversification of portfolio of securities. We have to undertake assest allocation to protect ourselves from Systematic risk - have different categories of assests - property, cash, equity shares, bonds, etc

Unsystematic risk refers to the risk associated with a particular security, company or industry. This risk arises due to the micro-economic factors, i.e. factors existing in the organization, is known as unsystematic risk. The risk can be avoided by the organization if necessary actions are taken in this regard.

Unsystematic risk has been divided into two category - business risk and financial risk

• Business risk: Risk inherent to the securities, is the company may or may not perform well. The risk when a company performs below average is known as a business risk. There are some factors that cause business risks like changes in government policies, the rise in competition, change in consumer taste and preferences, development of substitute products, technological changes, etc.
• Financial risk: Alternatively known as leveraged risk. When there is a change in the capital structure of the company, it amounts to a financial risk. The debt – equity ratio is the expression of such risk.

Unsystematic risk is the risk which emerges out of controlled and known internal variables, that are industry or security specific.This risk affects prices of security of a particular company. The diversification of portfolio proves helpful in avoiding unsystematic risk - having equity in different industry like banking, cement, finance, automobile, pharmacuetical, etc