The term risk refers to derivation from an expected outcome. The risk of holding an investment is generally associated with the rate of return. There are two types of risks that affect the rate of return of the securities.
Systematic Risk (SR) is also called non-diversifiable or market risk. Systematic risk refers to the variability of return of portfolio associated with change occurring in the economic, political and social system.
When considering “risk” or “systemic risk”, two things are usually meant: firstly, the potential consequences of some external action on the whole economy, and secondly, the potential repercussions that such an external action has on the “system” or “systemic” risks. As an example, one could say that an economic downturn in a country may be “systemic”, and, as a consequence, a default of a currency might be “systemic”. This is also sometimes used in finance.
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.
Total Risk= Systematic risk + unsystematic risk.
There are two major systematic risks – political and economic – that you may face in your financial life. Economic risk refers to the variability of return of portfolio associated with a change in the economy. Political risk refers to the risk of political disruption of an economy or state. An economy or a country is politically stable when its internal issues are solved by people in power. A political threat can be as small as a coup d’état and as large as a war. Political unrest, corruption, inflation, and natural disaster are examples of political risks.
These risks cannot be diversified, in simple terms they are unavoidable. Systematic Risk of securities is measured by statistical measures called Beta.
Systematic risk is divided into three parts such as – interest rate risk, market risk, and purchasing power 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 particular 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 the change in its market. The variation in bond prices caused due to variations in interest rates is known as interest rate 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 takes the decision to purchase a security, he forgoes the opportunity cost to buy the goods and services.