Question

1) explain the importance of systematic risk and unsystematic risk in risk managament? 2) Discuss the positive and negative aspects of systemstic risk and unsystematic risk?

Answer 1

The systematic risk is the entire risk associated with the entire market or overall economy. This risk cannot be reduced through diversification as all indutries/stocks are affected by the same. It would include macro factors such as inflation risk, interest rate risk and currency risks.

The unsystematic risk is the risk which is typical to the industry or the security/stock. This is due to the unique nature of the business and its earning potential.

For efficient risk management, both the risks needs to be understood and managed. The unsystematic risk can be reduced through diversification and the systematic risk can also be monitored through analysis of macro parameters.

The positive impact of the systematic risk is that an investor could do little to change the systematic risk and this portion of the risk is same for all investors in the economy. So this is not a parameter for judging the risk management of a fund manager. Also, the systematic risk cannot be removed from an investment and this is the biggest drawback as well.

With regards to unsystematic risk, the biggest advanatge is that it can be reduced or managed through efficient diversification. The disadvantage is that if the returns of the other securities which are included to diversify the risk are correlated, then the systematic risk actually does not decrease significantly. So an estimation of future correlation of return of stocks needs to be done, which is not feasible.