i. The concept of systematic risk and how it is related to other types of risk such as common risk, idiosyncratic risk or independent risks.

There is different type of risk in evaluating an investment that are commonly used by decision makers in both private corporations and public agencies. Each of these types when used properly, a manager can increase portfolio returns or reduce risk to optimize an investment portfolio. However, it is important to define these types of risk precisely.

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Systematic Risk
Systematic risk, This type of risk is also called common risk, undiversifiable risk, or market risk. This risk is associated with market returns, which can be attributed to broad factors. It is risk to your investment portfolio that cannot be attributed to the specific risk of individual investments.
Fluctuations of a stock’s return that are due to market-wide news represent common
risk. As with earthquakes, all stocks are affected simultaneously by the news.

Sources of systematic risk is due to market wide news which could be macroeconomic factors such as changes in interest rates, inflation, fluctuations in currencies, wars, recessions, etc.
Macro factors which influence the direction and volatility of the entire market would be systematic risk. An individual organization cannot control systematic risk.
Systematic risk can be partially mitigated by asset allocation. Owning different asset classes with low correlation can smooth portfolio volatility because asset classes react differently to macroeconomic factors. When some asset categories (i.e. domestic equities, international stocks, bonds, cash, etc.) are increasing others may be falling and vice versa.
To further reduce risk, asset allocation investment decisions should be based on valuation. I want to adjust my asset allocation target according to valuations. I want to overweight those asset classes that are bargains and own less or avoid investments which are overpriced. When mitigating systematic risk within a diversified portfolio, cash may be the most important and under appreciated asset category.

Unsystematic Risk
Unsystematic risk, This type of risk is also called idiosyncratic risk or independent risk. This is risk attributable or specific to the individual investment or small group of investments. It is uncorrelated with stock market returns. Other names used to describe unsystematic risk are specific risk, diversifiable risk, idiosyncratic risk, and residual risk.
Examples of risk that might be specific to individual companies or industries are business risk, financing risk, credit risk, product risk, legal risk, liquidity risk, political risk, operational risk, etc. Unsystematic risks are considered governable by the company or industry.
Proper diversification can nearly eliminate unsystematic risk. If an investor owns just one stock or bond and something negative happens to that company the investor suffers great harm. But if an investor owns a diversified portfolio of 20, 30, or 40 individual investments, the damage done to the portfolio is minimized.
The important concept of unsystematic risk is that it is not correlated to market risk and can be nearly eliminated by diversification.

Intuitively, the key difference between them
is that an earthquake affects all houses simultaneously, so the risk is perfectly correlated
across homes. We call risk that is perfectly correlated common risk. In contrast, because
thefts in different houses are not related to each other, the risk of theft is uncorrelated
and independent across homes. We call risks that share no correlation independent risks.
When risks are independent, some individual homeowners are unlucky and others are
lucky, but overall the number of claims is quite predictable. The averaging out of independent
risks in a large portfolio is called diversification.

Independent risks
are diversified in a large portfolio, whereas common risks are not.

What causes dividends or stock prices, and therefore returns, to be higher or lower than we
expect? Usually, stock prices and dividends fluctuate due to two types of news:
1. Firm-specific news is good or bad news about the company itself. For example, a
firm might announce that it has been successful in gaining market share within its
2. Market-wide news is news about the economy as a whole and therefore affects all
stocks. For instance, the Federal Reserve might announce that it will lower interest
rates to boost the economy.

Fluctuations of a stock’s return that are due to firm-specific news are independent risks.
Like theft across homes, these risks are unrelated across stocks. This type of risk is also
referred to as firm-specific, idiosyncratic, unique, or diversifiable risk.
Fluctuations of a stock’s return that are due to market-wide news represent common
risk. As with earthquakes, all stocks are affected simultaneously by the news. This type of
risk is also called systematic, undiversifiable, or market risk.

When we combine many stocks in a large portfolio, the firm-specific risks for each stock
will average out and be diversified. Good news will affect some stocks, and bad news will
affect others, but the amount of good or bad news overall will be relatively constant. The
systematic risk, however, will affect all firms-and therefore the entire portfolio-and will
not be diversified.


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