What do you mean by Systematic Risk
Systematic risks are market risks or undiversifiable risks, and the essential characteristic is that these are inherent risks that have an effect on the whole financial market or at least a large segment of it.
Unlike those risks attributed to individual companies or industries, systematic risks impact all companies and sectors, though to different extents, while being driven by macro factors such as interest rates, inflation, political instability, and economic recessions. Since systematic risk is a risk that affects the whole market, it is impossible to remove it via diversification. It requires other strategies for managing risk instead.
It is often said that “systemic risk” represents the possibility of an adverse global event having the potential to affect and impair all economies and financial markets in the world. A few examples of such adverse events include loss of confidence in financial institutions due to economic and political crises; the potential bankruptcy of a major company; the collapse of a government and so on.
Examples of Systematic Risk
Economic Recession: During a recession, consumer spending decreases, companies reduce production, and unemployment rises. This affects corporate profits and, consequently, stock prices across sectors, making the entire market more volatile.
Inflation and Interest Rates: Rising inflation reduces the purchasing power of consumers and can lead to an increase in interest rates by central banks, which impacts borrowing costs for businesses and consumers. This has a widespread effect on stock, bond, and real estate markets.
Geopolitical Events: Wars, political unrest, and international conflicts disrupt global markets and affect supply chains, causing widespread uncertainty. As a result, markets experience heightened volatility, affecting both equities and commodities.
Key Characteristics of Systematic Risk
One of the hallmarks of systematic risk is that it impacts every type of asset in a market. For example, a sudden increase in interest rates impacts not just one company but all companies in an economy because it impacts borrowing costs, the spending of consumers, and business investment. Similar is the case with geopolitical tensions or unforeseen downturns in the economy, which cause widespread volatility in the stock market and impact returns on investments on many types of assets.
Due to its wide scope, systematic risk is usually outside the control of individual investors or businesses; it is often associated with the general economic or financial structure rather than the specific industry or company. Systematic risk is also assessed through beta, which is a measure of how sensitive a given asset or portfolio might be to market movement. High beta values reveal greater exposure to systematic risk.
Interest rate risk
Interest rate risk is a term used by market practitioners to refer to the risk that an interest rate payment might be made at a future time that is out of line with the prevailing market rate.
In effect, interest rate risk is the risk that market rates will go down, and in the event that a loan is taken out based on a borrowing rate that is no longer valid, the lender will be exposed to a loss.
Interest rate risk particularly affects the value of debt securities like bonds and debentures. The fixed coupon rate of interest pays on these securities. The change in the market rate of interest relative to the coupon rate of a bond causes a change in its market. The variation in bond prices caused due to variations in interest rates is known as interest rate risk.
Market Risk
Market risk is a type of systematic risk that affects shares. Generally, the rise in the price of stock refers to the bullish market and the fall in the price of stocks refers to the bearish market. The stock market is seen to be volatile. The variations in returns caused by the volatility of the stock market are referred to as market risk.
Purchasing Power Risk
Purchasing power risk is a type of systematic risk. It refers to the variation in investors’ returns caused by inflation. Inflation results in a lowering of purchasing power of people. If an investor makes the decision to purchase a security, he forgoes the opportunity cost to buy the goods and services.
Conclusion
Conclusively, systematic risk is an essential element that impacts everybody who invests in the economy. It is driven by things that affect the whole economy as well as the financial markets and cannot entirely be avoided by people; however, investors can reduce its impact by careful planning, diversified portfolios, and strategic application of hedging tools.