Systematic Risks

Have you ever wondered why the stock price of a company has plummeted despite exceptional company performance in the last quarter? The economic downturn can affect seemingly unrelated companies across different sectors, and all the stock prices can experience a synchronised decline. This is due to the systematic risk that affects all the stocks regardless of the industry. In this blog, we will learn what is systematic risk and understand how it can impact your investment. This can help you make more informed decisions to mitigate its impact on your portfolio.

What is Systematic Risk?

Systematic risk refers to the total risk caused by various factors beyond the control of a specific company or an individual. These external factors affect all types of securities or investments. It is also a non-diversifiable risk because diversification will not reduce this type of external risk. Regardless of the number or type of securities you hold, your investment is always subject to systematic risk.

The stock market has experienced different types of systemic risk throughout its history. The Great Recession of 2008 resulted in a market crash, which is a classic example of systematic risk. The failure of major financial institutions in the US led to a widespread decline in worldwide stock markets. More recently, the COVID-19 pandemic resulted in a global lockdown, creating economic disruption. The combination of socio-political and market risk impacted every sector, resulting in a sharp decline in the market.

Types of Systematic Risk

Different types of systematical risks are explained below:

Market Risk

In any market, investors have a herd mentality. They move according to the direction of the market. Due to the large number of investors following the market direction, the market continues to move in the same direction. So, the security prices in the market also move in the same direction. Thus, in a declining market, the stock prices of companies with solid fundamentals will also fall. This is called the market risk.

Market risk contributes to two-thirds of the total systemic risk of any security. Many Investors use systemic risk and market risk to mean the same thing. The changing market prices of stock is one of the biggest risks for investors in the share market.

Interest Rate Risk

The rate of interest in the economy keeps changing based on local, global, and market conditions. The changing market interest rate affects bond prices and other fixed-income securities. This is called interest rate risk. The bond prices move in the opposite direction of the market interest rate.

Interest rate risk is further classified into price risk and reinvestment risk. These risks move in the opposite direction. Price risk moves with changing security prices due to varying interest rates. Reinvestment risk is the risk of investing the dividend or income back in the current market rate. As they have an inverse relationship, the reinvestment risk will be positive if the price risk is negative. All fixed-income securities, including bonds and debentures, are affected by the interest rate risk.

Purchasing Power Risk or Inflation Risk

Another risk common for all market securities is due to inflation. The sustained and persistent rise in the general price level of an economy is called inflation. Due to this, the purchasing power of money decreases.

For example, with Rs.45, you could buy a litre of milk today. However, it will not be the case a few months later. Consumers experience inflation as an increase in the price of all goods and services. What you can afford with your money right now will become unaffordable in the future due to inflation.

So, investors must consider this inflation risk when choosing investments. If your income from the investment does not increase in proportion to the increasing inflation rates, you will get lower income in real-time.

Inflation risk is much higher with fixed-income securities. As the income from such securities is fixed, they are highly susceptible to increasing inflation rates. Equity investments offer to hedge against inflation as equity prices can appreciate over time.

Exchange Rate Risk

Almost all companies are exposed to foreign currency in the global economy. So, they have to deal with exchange rate risk, which is the uncertainty of the value of foreign currencies. However, not all securities will be affected by exchange rate risk. Those securities that have exposure to foreign exchange transactions, like MNCs, export companies, or companies importing raw materials or products, will be affected by the exchange rate risk.

Political Risk

Changes in government policies, regulatory changes, or general political stability can also impact market movement. This is called political risk, and it varies from one country to another. Many times, investment in one country may be affected by political uncertainty or instability in another country, given the interconnection of government trading policies. Generally, geopolitical conditions can affect market variations in India.

Commodity Risk

The prices of commodities like gold, oil, agriculture products, steel, metal and others change due to supply-demand fluctuations. Commodity risk varies according to the commodity prices, and this type of risk also impacts companies in the distribution, transportation, or production of these commodities.

Calculation of Systematic Risk

The systematic risk cannot be determined as an accurate value. However, the sensitivity of returns from a security relative to the overall market return can be captured using the beta coefficient (β). The regression of the security's return on market return gives the systematic risk associated with a security.

The formula for systematic risk calculation is:

• Where Ri = Return of the asset (i),
• Rm = Return of the market,
• Cov (Ri, Rm) = covariance between the returns of the asset and the market
• Var (Rm) = variance of the market returns

Covariance measures how the asset returns and market move together. A positive covariance means the return from the assets moves in the same direction as the market. They will move in opposite directions in case of a negative covariance. Variance is the dispersion of the market returns. In volatile markets with high fluctuations, the variance will be higher, too.

• β > 1 -  The asset is more volatile than the market, and it amplifies the market's movements.
• β = 1 -  The asset's volatility is in line with the market.
• β < 1 -  The asset is less volatile than the market, and it dampens the market's movements.

Difference Between Systematic Risk and Unsystematic Risk

Unlike systematic risk, which affects the entire market, unsystematic risk is specific to a company. Events or operations within the company can result in devaluation of the stock price in the market, resulting in the market price going down or stock crashing. Here is a table that highlights the difference between systematic risk and unsystematic risk:

Conclusion

Systematic risk is a pervasive force in the financial markets, affecting all types of investments. It's caused by external factors beyond the control of individual companies or investors, making it unavoidable. Understanding the different types of systematic risk is crucial for making informed investment decisions. Through diversification and calculated asset allocation, you can manage this risk to some extent.
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