Question

6.a) What is the difference between systemic risk and idiosyncratic risk? Which type of risk can be almost eliminated through diversification? Who will be able to mitigate the risk and how?

What is “moral hazard” and ‘adverse selection”?

What are the cause and remedies of the financial crisis in 2008-09?

Answer 1

Answer 6- The difference between systemic risk and idiosyncratic risk are-

1. Systemic risk refers to the risk associated with the collapse or failure of a company, industry, financial institution, or an entire economy. Such failure of a financial system occurs when a crisis occurs in case providers of capital, i.e., depositors, investors, and capital markets, lose trust in the users of capital, i.e., banks, borrowers, leveraged investors, etc. or in a given medium of exchange (US dollar, Indian rupee, gold, etc.). Systemic risk is inherent in a market system itself and hence it is an unavoidable risk.

Idiosyncratic risk, also known as unsystematic risk, is the risk involved in investing in a specific asset – such as a stock. This risk, unlike systemic risk doesn’t affect the entire market or an entire investment portfolio. It is the opposite of systemic risk, which affects all assets. Systemic risks include things such as changing interest rates or inflation.

2. The most important feature of systemic risk is that this type of risk spreads from unhealthy institutions to relatively healthier institutions through a transmission mechanism. Whereas, idiosyncratic risks are more rooted in individual companies (or individual investments) and do not transmit from one institution to another. The investors can mitigate or avoid idiosyncratic risks by diversifying their investment portfolios.

3. With idiosyncratic risk, factors that affect assets such as stocks and the companies underlying them and it makes an impact on a micro-economic level. It means that idiosyncratic risk has little or no correlation to overall market risk. Systemic risk, on the other hand, involves macroeconomic factors that affect not just one asset, but most assets, as well as the market and various economies in general. It shows correlation to overall market risk. One cannot counteract systemic risk by diversifying the assets within.

Idiosyncratic risk can be eliminated. If an investor is looking to cut down on the idiosyncratic risk he can accomplish it through investment tactics such as "diversification and hedging". The strategy involves diversifying assets by investing in a variety of assets with low correlation, i.e., assets that don’t have same movement in the market. The motto of diversification is that even if one or more assets lose money, the rest of an investor’s non-correlated investments gain, thus hedging or avoiding his losses.

Moral hazard is the risk that occurs when a party while getting insured has not provided misleading information about its assets, liabilities, or credit capacity. In addition, moral hazard also may mean a party, either the insurance company or insured party, has an incentive to take unusual risks in a desperate attempt to earn a profit by providing false information. Moral hazards can be present at any time two parties come into agreement with one another where each party in a contract may have the opportunity to gain. For example, the concept of moral hazard suggests that customers who have insurance against their car may be more likely to drive recklessly than those who do not have insurance of their car.

Adverse selection is a market situation where buyers and sellers have different or incomplete information, so that a participant might participate selectively in business which benefit them the most, at the expense of the other trader. Eg- market for lemons or market for used (second hand cars) where buyers do not have full information about the quality of cars.

The concept of adverse selection and moral hazard is related . Adverse selection describes a situation where the type of product is hidden in a transaction, moral hazard describes a situation where the action is hidden in the transaction.

Cause of the financial crisis in 2008-09-

• The US Senate's Levin–Coburn Report concluded that the crisis was the result of "high risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street".
• The Financial Crisis Inquiry Commission concluded that the financial crisis was avoidable and was caused by "widespread failures in financial regulation and supervision", "dramatic failures of corporate governance and risk management at many systemically important financial institutions", "a combination of excessive borrowing, risky investments, and lack of transparency" by financial institutions, ill preparation and inconsistent action by government that "added to the uncertainty and panic", a "systemic breakdown in accountability and ethics", "collapsing mortgage-lending standards and the mortgage securitization pipeline", deregulation of over-the-counter derivatives, especially credit default swaps, and "the failures of credit rating agencies" to correctly price risk.
• The 1999 part-repeal of the Glass-Steagall Act effectively removed the separation between investment banks and depository banks in the United States.
• Critics argued that credit rating agencies and investors failed to accurately price the risk involved with mortgage-related financial products, and that governments did not adjust their regulatory practices to address 21st-century financial markets.
• Research into the causes of the financial crisis has also focused on the role of interest rate spreads.

Remedies of the financial crisis in 2008-09-

There are a number of tools that policymakers have at their disposal in order to try and boost economic activity. One of the most common is to lower interest rates. You lower interest rates, and debt becomes cheaper. More people borrow to buy stuff, because they can “afford” it, and economic activity increases. However, the Fed’s benchmark rate has been near zero for years, so it needs to do something else.

Quantitative easing is a “non-traditional” way of stimulating the economy. It refers to pumping quantities of money into the economy. This essentially increases the money supply, making money cheaper to get, and encouraging consumer behaviors that supposedly boost the economy and result in hiring as businesses try to keep up with demand.