Risk is the probability of an individual or organization incurring a loss. Risk can be classified as market risk, credit risk, operational risk, liquidity risk, and compliance.
In finance, the risk is the chance that the actual rate of return on an investment will be different from what was originally expected. An investor can assess how risky an investment is by looking at three factors: the amount of uncertainty in the underlying return, the degree of correlation to other investments, and the length of time until an investment matures.
Broad Categories of Risks in Finance
The deviation from the anticipated return is caused by is explained by 2 levels of risk: systematic risks and unsystematic risks. The sum of these two main categories of risk is the total risk to which an investor is exposed.
“Systematic risk” or “Risk” means a risk that is common to all possible courses of action and can be quantified for a specified set of circumstances. It includes risks to the financial integrity and long-term viability of the organization. Systematic risk is contrasted with “Unsystematic risk” or “Risk”. It is the risk arising from the inherent nature of a business. Unlike systematic risk, it cannot be precisely quantified. For example, inflation could increase the cost of a business. This would increase the cost of goods sold. However, this risk could be offset by increasing the selling price of the goods.
Systematic risk is associated with overall movements in the general market or economy and therefore is often referred to as the market risk. The market risk is the component of the total risk that cannot be eliminated through portfolio diversification.
These are also known as undiversifiable risks. Many academics believe that reward for credit risk from the portfolio angle is the return for the systematic risk undertaken by the lenders (because all non-systematic risk can be diversified away).
Systematic risks are typically those that occur across an entire market, such as a recession. Unsystematic risks generally occur within a single company, for example, a company made a poor decision to refuse to produce goods that have been requested by consumers.
Unsystematic risks are the component of the portfolio risk that can be eliminated by increasing the portfolio size, the reason being that risks that are specific to individual security such as business or financial risk can be eliminated by constructing a well-diversified portfolio. These are known as diversifiable risks. One example of unsystematic risk is a C.E.O. resigning from the post. It is a company-wide issue, not the nation or economy-wide.
Unsystematic risk is the risk of loss that cannot be diversified away through investment in any of the securities in a broadly diversified portfolio. This non-diversifiable risk applies to all securities, and it has no bearing on the overall market cycle of an economy.