Page 62 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 4: Risk and Return Analysis

The first three risk factors discussed below are systematic in nature and the rest are unsystematic. Notes
Political risk could be categorised depending on whether it affects the market as whole, or just
a particular industry.

4.1 Types of Investment Risk

Systematic versus Non-systematic Risk

Modern investment analysis categorizes the traditional sources of risk causing variability in
returns into two general types: those that are pervasive in nature, such as market risk or interest
rate risk, and those that are specific to a particular security issue, such as business or financial
risk. Therefore, we must consider these two categories of total risk. The following discussion
introduces these terms. Dividing total risk into its two components, a general (market) component
and a specific (issuer) component, we have systematic risk and non-systematic risk, which are
additive:

Total risk = General risk + Specific risk
= Market risk + Issuer risk
= Systematic risk + Non-systematic risk

Systematic Risk: An investor can construct a diversified portfolio and eliminate part of the total
risk, the diversifiable or non-market part. What is left is the non-diversifiable portion or the
market risk. Variability in a security's total returns that is directly associated with overall
movements in the general market or economy is called systematic (market) risk.

Virtually all securities have some systematic risk, whether bonds or stocks, because systematic
risk directly encompasses interest rate, market, and inflation risks. The investor cannot escape
this part of the risk because no matter how well he or she diversifies, the risk of the overall
market cannot be avoided. If the stock market declines sharply, most stocks will be adversely
affected; if it rises strongly, as in the last few months of 1982, most stocks will appreciate in
value. These movements occur regardless of what any single investor does. Clearly, market risk
is critical to all investors.
Non-systematic Risk: The variability in a security's total returns not related to overall market
variability is called the non-systematic (non-market) risk. This risk is unique to a particular
security and is associated with such factors as business and financial risk as well as liquidity risk.
Although all securities tend to have some non-systematic risk, it is generally connected with
common stocks.

Caution Remember the difference: Systematic (market) risk is attributable to broad macro
factors affecting all securities. Non-systematic (non-market) risk is attributable to factors
unique to a security.
Different types of systematic and non-systematic risks are explained as under:

1. Market Risk: The variability in a security's returns resulting from fluctuations in the
aggregate market is known as market risk. All securities are exposed to market risk
including recessions, wars, structural changes in the economy, tax law changes and even
changes in consumer preferences. Market risk is sometimes used synonymously with
systematic risk.

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