In: Economics
Identify and describe two or more risks that you would categorize as systematic, and one risk that you would categorize as idiosyncratic. Which risk factors can you identify as being dependent on changes in the interest rate? Comment on how changes in the price level or the interest rate may be important for this firm to incorporate into management decisions as a strategic consideration.
Idiosyncratic risk or Unsystematic
risk, also known as "specific risk," "diversifiable risk" or
"residual risk," is the type of uncertainty that comes with the
company or industry you invest in. Unsystematic risk can be reduced
through diversification. For example, news that is specific to a
small number of stocks, such as a sudden strike by the employees of
a company you have shares in, is considered to be unsystematic
risk. Systematic risk, also known as "market risk"
or "un-diversifiable risk", is the uncertainty inherent to the
entire market or entire market segment. Also referred to as
volatility, systematic risk consists of the day-to-day fluctuations
in a stock's price. Volatility is a measure of risk because it
refers to the behavior, or "temperament," of your investment rather
than the reason for this behavior. Because market movement is the
reason why people can make money from stocks, volatility is
essential for returns, and the more unstable the investment the
more chance there is that it will experience a dramatic change in
either direction.
Interest rates, recession and wars all represent sources of
systematic risk because they affect the entire market and cannot be
avoided through diversification. Systematic risk can be mitigated
only by being hedged. Systematic risk underlies all other
investment risks. If there is inflation, you can invest in
securities in inflation-resistant economic sectors. If interest
rates are high, you can sell your utility stocks and move into
newly issued bonds. However, if the entire economy underperforms,
then the best you can do is attempt to find investments that will
weather the storm better than the broader market. Popular examples
are defensive industry stocks, for example, or bearish options
strategies.