Question

Q1) Suppose an investor wishes to invest in a computer manufacturing firm whose main business is exporting computers. The firm has several rival companies that also export computers to the same market.

From the perspective of the investor, is the following a systematic risk or an unsystematic risk? How can an investor manage such risks when making investment decision? Explain your views.

1. The firm has a very high level of debt, and there are concerns that it may collapse in future if the business operation does not improve.
2. There are concerns that demand for computers is dropping in the target market.       
   

Answer 1

Risk is an inherent concept to be considered in every investment. Two major components of risk are systematic risk and unsystematic risk. Systematic risk is a result of external and uncontrollable factors. These might not industry or sector or security specific and it can affect the entire market leading to the fluctuation in prices of all the assets / businesses / securities / investements.

On the other hand, Unsystematic risk refers to the risk which emerges out of controlled and known variables that are industry or sector or security specific.

Systematic risk cannot be eliminated by diversification of portfolio, multi businesses / sectors, whereas the diversification proves helpful in avoiding unsystematic risk.

Examples of risk that might be specific to individual companies or industries are business risk, financing risk, credit risk, product risk, legal risk, liquidity risk, political risk, operational risk, Global factors etc. Unsystematic risks are considered governable by the Company or industry.

Factors for Comparison	Systematic Risk	Unsystematic Risk
Meaning	Risk associated with the market or market segment as a whole.	Risk associated with a particular security, company or industry.
Nature	Uncontrollable	Controllable
Factors	External factors	Internal factors
Affects	Large no. of companies, industries, investments, countries, etc	Only particular company / investment
Types	Interest risk, market risk and purchasing power risk	Business risk and financial risk
Protection	Asset allocation	Portfolio diversification

How can an investor manage such risks when making investment decision?

1. The firm has a very high level of debt, and there are concerns that it may collapse in future if the business operation does not improve. This is an Unsystematic risk, which is specific to this manufacturing entity. Debt levels always need to be monitored with respect to the overall Liabilities, otherwise. the cost of debt shall erode the overall earnings from the Operations; In this case, the investor need to reduce the debt burden using partial prepayments, Debt-Restructuring to allow sufficient Moratorium period to pay the Principal components, or Debt conversion in to Equity.
2. There are concerns that demand for computers is dropping in the target market. This is a Systematic risk, which is sectoral and is uncontrollable from the entity perspective. In these scenarios, generally asset diversification or Product diversification or market diversification need to be implemented;This helps in risk mitigation expected from the target market and for the target product. Also, the demand forecasts and budgets need to be revisited to control the costs and inventory requirement to avoid any unnecessary holding costs.