Question

-do you think the systematic risk and unsystematic risk is old fashion or currently useful? -make a strong conclusion for explaing of systematic risk and unsystematic risk

Answer 1

Systematic risk and unsystematic risks are universally useful concepts like discounted cash flow, bond duration etc which are useful at any time.

Risks can be expressed standard deviation of return. Higher the variability of return measured by standard deviation, higher is the risk.

Systematic risk is the risk of the loss due to variability of return of the market itself and relationship of the return of the stock in relation to the return of the market. If the market goes up, the stocks will also go up. The extent of going up will depend on the Beta of the stock. If Beta is equal to one, the stock price will move at a same percentage as the market. If Beta is less than one, it will move less than the market. If Beta is greater than one, it will move more than the market. Systematic risk can be measured by the Beta of the stock.

Unsystematic risk is the risk of loss due to variability of stock price without reference to the movement of the market. Unsystematic risks can be measured by the Standard Deviation of the return of the stock.

Systematic risk can be measured but cannot be reduced.

Unsystematic risks can be measured by standard deviation of the stock. Unsystematic risk can be reduced through diversification.

Diversified folios reduce the risk and also the ratio of Risk to reward.

If w1, w2 , w3 …wn are weight in the portfolio for assets 1, 2,3 ….n

Then,w1+w2+w3+……………………+wn=1

R1, R2,R3,…….Rn are the return of the assets 1, 2 , 3 ….n

S1, S2, S3……Sn are the standard deviation of the assets 1, 2, 3 …n

Portfolio Return=w1R1+w2R2+w3R3+…….+wnRn

Portfolio Variance=(w1^2)*(S1^2)+(w2^2)(S2^2)+………….(wn^2)*(Sn^2)+2w1w2*Cov(1,2)+2w1w3*Cov(1,3)+………+w(n-1)wn*Cov(n,(n-1)

Cov(1,2)=Covariance of returns of asset1 and asset2

Portfolio Standard Deviation =Square root of Portfolio variance

Risk of a stock is measured by standard deviation.

Hence reduction of standard deviation through diversification means reduction of risk.

We can take a simple example of two assets 1 and 2

Return of asset1=R1=15%

Return of asset2=R2=12%

Standard deviation of asset 1=S1=10%

Standard deviation of asset 2=S2=8%

Correlation of asset 1 and 2=Corr(1,2)=0.1

Covariance(1,2)=Corr(1,2)*S1*S2=0.1*10*8=8

Assume for simplicity, equal amount is invested in asset 1 and asset 2

Hence, w1=w2=0.5

Portfolio Return;

0.5*15+0.5*12=13.5%

Portfolio Variance=(0.5^2)*(10^2)+(0.5^2)*(8^2)+2*0.5*0.5*8=45

Portfolio Standard Deviation=Square root of Variance=(45^0.5)= 6.708204

We can see, the risk of portfolio as measured by Standard Deviation has reduced significantly to 6,7 whereas the assets in the portfolio had standard deviation of 10 and 8

Risk / Return ratio of the portfolio=6.7/13.5=0.496

Risk/Return ratio of asset1=10/15= 0.666667

Risk/Return ratio of asset2=8/12= 0.666667

Risk return ratio of the portfolio is lower