Question

Distinguish between unique/firm specific risk and systematic/market risk for an individual stock which of these does the market used to determine the riskiness and therefore the price of the stock?

Answer 1

Solution:

Both systematic and Unsystematic Risk are inevitable in any kind of financial decision and accordingly, one should be equipped to handle them in case they occur.

• Systematic Risk is a market risk does not have a exact definition but is inherent risk existing in the stock market. These risks are related to all the sectors but can be controlled. If there is a declaration or event which impacts the whole stock market, a reliable response will drift in which is a systematic risk. For e.g. if Government Bonds is offering a yield of 5% in contrast to the stock market which offers a least return of 10%. Unexpectedly, the government declares an additional tax load of 1% on stock market dealings, this will be a systematic risk influence all the stocks and may make the Government bonds more attractive.
• Specific risk is a unique or firm-specific risk in each kind of investment. It is also known as “un systematic Risk”, or “Residual Risk”. These are risks which are prevailing but are unintended and can happen at any point in causing extensive trouble. For e.g., if the staff of the airline industry goes on an unspecified strike, then this will reason of risk to the shares of the airline industry and reduction in the prices of the stock influence this industry.

One should always keep in mind the below formula which in a nutshell highlights the position and importance of these 2 types of risks confronted or faced by all classes of investors:

Total risk = systematic risk + specific risk

The above risks cannot be evaded but the after affect can be limited with the assistance or help of variation of shares into diverse subdivisions for balancing the negative effects.

differnce between systematic risk and specific risk:

differences	systamatic risk	specific risk
meaning	risk associated with the market or segment as whole.	risk associated with specific security firm or industry.
impact	large number of securities in the market	restricted to the specific industry
controllability	cannot be controlled	controllable
hedging	allocation of the asset	diversification of the portfolio
types	interest risk and market risk	financial and business specific risk