Page 75 - DCOM507_STOCK_MARKET_OPERATIONS

Stock Market Operations

Notes understood as the probability that the expected return from the security will not materialise.
Every investment includes uncertainties that make future investment returns risk-prone.
Uncertainties could be owing to the political, economic and industry factors.
Risk could be systematic in future depending on its source. Systematic risk is for the market as
a whole, whereas unsystematic risk is particular to an industry or the company alone. The first
three risk factors discussed below are systematic in nature and the rest are unsystematic. Political
risk could be categorised depending upon whether it affects the market as whole, or only a
particular industry. Hence, in this unit we will study about the various types of risk involved in
investment and the risk and return relationship.

4.1 Types of Investment Risk

The various types of investment risk are discussed as follows:

4.1.1 Systematic versus Non-systematic Risk

Modern investment analysis categorises the traditional sources of risk causing variability in
returns into two broad 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. Thus, we must take into account these two categories of total risk. 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 make a diversified portfolio and do away with the 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 related with overall movements in the
general market or economy is called systematic (market) risk. Almost all securities have some
systematic risk, whether bonds or stocks, as systematic risk directly cover interest rate, market,
and inflation risks.

Non-systematic Risk

The variability in a security’s total returns not associated to overall market variability is called
the non-systematic (non-market) risk. This risk is exclusive to a specific security and is linked
with such factors as business and financial risk as well as liquidity risk. Though all securities
tend to have some non-systematic risk, it is normally connected with common stocks.
Different types of systematic and unsystematic risks are explained as follows:

1. Market Risk: The unpredictability 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 as well as
changes in consumer choice. Market risk is at times used synonymously with systematic
risk.
2. Interest Rate Risk: The variability in a security’s return consequential from variations in
the level of interest rates is referred to as interest rate risk. Such changes in general affect

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