What Is Systematic Risk?
Systematic risk is inherent in the whole market or a particular market segment. It is referred to as market risk since it is common to all investments and cannot be avoided by diversification. This risk occurs due to macroeconomic factors like inflation, interest rates, political turmoil, and recessions.
Formula Of Systematic Risk
Beta = Cov(Ri,Rm)/Var(Rm)
Beta- Beta coefficient (systematic risk)
Ri- Return of the individual asset
Rm- Return of the market
Cov(Ri,Rm)- Covariance between the asset's return and the market return
Var(Rm)- Variance of the market return
Types Of Systematic Risk
- Market Risk: The risk of loss resulting from general market fluctuations. Stock market crashes, and shifts in investor attitudes are among the factors that cause market risk.
- Interest Rate Risk: The risk resulting from a change in interest rate affects the cost of borrowing and the value of assets such as bonds and loans.
- Inflation Risk: The risk that increasing inflation will cut into the purchasing power of money and lower the actual returns on investment.
- Exchange Rate Risk: The risk that a change in foreign exchange rates will affect investments, particularly for businesses that engage in international business.
- Political and Regulatory Risk: The risk of governmental policy, tax, or regulatory changes impacting business and investments.
Benefits Of Systematic Risk
- Better Investment Options: Investors can analyse risk exposure and choose investments with appropriate levels of risk.
- Portfolio Optimization: Supports asset allocation and risk management strategies.
- Risk-adjusted Returns: Permits calculation of expected returns employing CAPM, which helps the investor compare investments.
- Macroeconomic Insights: Provides a broader overview of economic conditions that affect investments.
- Regulatory Compliance: Systemic risk analysis is utilised by financial institutions to comply with risk management regulations.
Key Takeaways
Systematic risk refers to the inexorable market-wide risk impinges on all investments based on macroeconomic determinants such as inflation, interest rates, and political instability. It cannot be diversified away and is quantified by Beta (β), which measures an asset's responsiveness to market fluctuations. Significant forms of systematic risk include market risk, interest rate risk, inflation risk, exchange rate risk, and political/regulatory risk. Understanding systematic risk helps improve investment choices, portfolio management, and regulatory requirements.
