Question

1) Information for this question: You are required to demonstrate your understanding of risk and how these impact companies and therefore returns for investing in these companies. You will demonstrate your understanding of systematic and unsystematic, business and financial risks in this question.

Tasks: Write your discussions in the text box provided and address the following questions.

• Contrast the difference between systematic and unsystematic risks and provide an example for each. You can use a company you are familiar with to contextualise your discussions.

• Contrast the difference between business and financial risks and provide an example for each. You can use a company you are familiar with to contextualise your discussions.

• Explain how an investor can diversify unsystematic risks that you have discussed here in a portfolio. (100 – 150 words)

Answer 1

· Systematic risk is the risk which is common across all securities and it can not be diversified away whereas the non-systematic risk is the risk which can be diversified by investing into securities whose returns are negatively correlated. Let’s take the example of a company in information technology sector, Intel, here for intel the main risk is that its product might become outdated because of technological development by its competitors. This can be an example of non-systematic risk whereas risk like rise in interest rate or war, terror attacks can be called systematic risk. These events will affect all the securities and can not be diversified away while an investor can diversify the technology risk by investing in consumer product company.

· Business risk is the risk relation to the operations of the company. The company sales might fall significantly, it can lose its market share, it’s customer might be driven towards other competitors’ product. The business risk is the risk which can affect the value of the business negatively. Financial risk is the risk related to leverage in the capital structure of the firm. The leverage means the way the debt and equity is employed in the capital structure to make the investment. Excess financial leverage means the company might not be able to generate enough profits in some years to pay the interest cost and it can raise bankruptcy issue.

· An investor can diversify unsystematic risk by investing in securities where the returns of the securities are negatively correlated. Negative correlation means that there would be inverse relation in the movement of the returns of the securities. Take for example in the case of Intel an investor can choose to invest in securities like oil company. Normally technological upgradation does not significantly affect the oil industry or for that matter investor can consider adding gold into their portfolio because normally when the economy is facing recession commodities do well. Like in the recent time when the economic activity has been falling because of the pandemic the demand for gold has been increased significantly because they do protect the portfolio.