Systematic risk is the risk associated with the environment a business operates in. This risk occurs due to external factors and is outside the control of a particular business. This risk applies to the market or market segment, the business operates in, as a whole and not to a particular company or industry.
Systematic risk cannot be diversified by investors for a particular class of investment as it relates to all investments of the same class in a market. Investors with a large number of different stocks and a diversified portfolio of investments still have to deal with systematic risks for investments in a particular market.
For example, if different investors have a diversified portfolio of different stocks, they will be affected the same during a stock market crash.
Instead, systematic risk can be managed or minimized, by investors, by to diversifying their portfolios with different classes of investments.
For example, an investor that has invested in only stocks of companies can minimize the systematic risk by investing in other classes of assets such as real estate.
In simple terms, investors can manage systematic risk by investing in a different market or market segment altogether.
Investors can also manage the systematic risks of their investments through hedging. For example, when the interest rates in the market increase, an investor that has invested in fixed interest rate instruments will be affected.
They can hedge the risk by using different tools such as Forward Rate Agreements, Futures, Swaps, Options, etc.
Systematic risk consists of many types of risks. It includes interest rate risk, which is the risk that investors have to bear due to interest rate changes in the market.
It also includes exchange rate risk, the risk which arises due to forex rate changes and effects the market as a whole. Additionally, it also includes inflation risk, risk which arises due to inflation changes.
Systematic risk can be better explained by understanding unsystematic risk first. Unsystematic risk or specific risk is the risk that is specific to a company or industry.
Unsystematic risk exists for every investment. However, unlike systematic risk, unsystematic risk can be managed, by investors, by diversifying their portfolios.
Unsystematic risk exists due to internal factors of the company or the industry unlike systematic risk, which exists due to external factors.
Therefore, this risk can be controlled by companies because it is internal. Because unsystematic risk is specific to an investment, it affects the market value of the investment only, while systematic risk affects the market value of the market as a whole.
The systematic risk of an investment can be measured by calculating the beta coefficient of the investment. The beta coefficient of an investment is the measure of its volatility compared to the market.
It illustrates how the value of the investment will change with changes in the systematic risk of the market it is operating in.
The value of the beta coefficient can be from 0 to 2 where if the value of the beta coefficient equals 1, the systematic risk of the investment is the same as the market as a whole.
If the beta coefficient of an investment lies between 0 and 1, i.e. lower than 1, then the systematic risk of the stock is said to be lower than that of the market as a whole.
This means that the investment is less risky as compared to the overall risk of the market. It also signifies that any changes in the risk of the market overall will have a lower impact on the risk of the company.
A beta coefficient between 1 and 2, i.e. greater than 1, indicates that the systematic risk of the company is higher than that of the market as a whole.
This means that the investment is riskier as compared to the overall risk of the market. Moreover, it signifies that any changes in the risk of the market overall will have a higher impact on the risk of the company.
Furthermore, beta coefficient quantifies the change in the value of an investment relative to the market it is operating in.
For example, if an investment has a beta coefficient of 1.3, it means that for every point change in the value of market as a whole, the value of the investment will change 1.3 times or 30% more than the change in the value of the market.
In contrast, if the beta of an investment is 0.7, for every point change in the value of the market overall, the value of the investment will change 0.7 times or 30% less.
To calculate the beta coefficient of a particular investment, the following formula can be used:
Beta Coefficient = Covariance (Return on individual investment, Return on overall market) / Variance (Return on overall market)
Covariance is the measurement of the changes in the returns on an investment relative to the changes in return on market overall.
This is calculated by taking the covariance of the relative changes of the values of the investment and the relative changes of the value of the market overall.
Variance is the measurement of how much the market’s data points are different to their average value or mean point.
This is calculated by establishing a mean value for the market and calculating any relative spread over the mean point.
Disadvantages of Using Beta Coefficient
While the beta coefficient can be used to measure the systematic risk of an investment, it has some disadvantages when used to calculate the systematic risk.
The calculation of beta coefficient only considers historical data when measuring the systematic risk of an investment. This means this tool does not provide an accurate systematic risk for investors looking to predict future information about an investment.
The beta coefficient is only useful when it comes to calculating the short-term systematic risk of an investment. For long term purpose the beta coefficient cannot be relied on to estimate systematic risk accurately due to the volatility of the data used in the calculation of beta coefficient.
The value of investment and market as a whole are unstable and can change significantly due to unforeseen circumstances.
The systematic risk of an investment is the risk due to the market it operates in and does not relate to a specific investment or industry.
This is different to unsystematic risk which is the risk associated with a particular investment or industry. The systematic risk of an investment can be measured using the beta coefficient.