Question

a) Explain the difference between systematic risk and unsystematic risk.

b) What are some examples of each?

c) Assume you are considering an investment in a new medical company that has developed a tiny robot that enters the body and (hopefully) destroys cancer tumors. If it works in clinical trials, the company will have cured cancer (and be very valuable); if it fails in clinical trials, the robot will be killing patients (and the company will be worthless). Under the CAPM approach, should this company have a high beta or a low beta, and explain why should that be the case?

d) If you wanted to use the company to diversify your existing holdings and reduce your risk, would you rather its correlation coefficient to the rest of your investments be -0.2 or 0.6? Explain.

Answer 1

Answer(a): Difference between Systematic risk and Unsystematic risk-

Headings	Systematic risk	Unsystematic risk
Definition	It is the overall risk that affect whole stock market, industries and shares of the companies.	It is industry specific or company specific risk that affect only particular industry or company.
Other name	It is also called Market risk.	It is also called Diversifiable risk.
Minimized	This risk cannot be easily minimized, it can only be minimized by Asset allocation	This risk can be minimized by diversification, investor can invest into different stocks to diversify the risk.
Reasons	It happens due to macroeconomics and external factors	It arises due to microeconomics and internal factors.

Answer(b):

Examples of systematic risk- Interest rate risk, Purchasing power risk, exchange rate risk, market risk.

Examples of unsystematic risk- Company risk, financial risk, business risk.

Answer(c): Beta is a measure of sensitivity or risk of market or a particular security or portfolio with respect to overall market. As per CAPM, The company will have high beta because the product has not been successful yet, it is yet to try and it may fail also. Many types of cancers are non curable. So there is a high risk in this company to get the product approved and to become successful. Hence it will have higher beta.