Systematic risk is the risk that results from economy-wide factors and affects all investments to varying extent. It is also called market risk or undiversifiable risk. Beta coefficient is a measure of a stock's systematic risk. Based on the capital asset pricing model, it is the only risk which ought to be compensated by higher return.
An equity investment is considered risky when its return varies. There are two main sources of such variation: (a) factors that are unique to the investment and (b) broad external factors unrelated to the individual investment-specific factors.
Systematic Risk vs Unsystematic Risk
The risk that arises from unique factors is called unique risk or unsystematic risk. Unique risk can be diversified by holding a well-balanced portfolio. In a portfolio context, positive variations in some assets that arise from investment-specific factors balances out negative variations in other assets from unique factors. Hence, unique risk is also called diversifiable risk because it can be eliminated by diversification. The second type of risk which is caused by economy-wide factors cannot be reduced or eliminated through diversification because the economy-wide factors negatively affect all the investments in an investment class. The risk arising from the broad economy-wise factors is called systematic risk. Because systematic risk cannot be diversified by increasing the number of assets in a portfolio, it is also called undiversifiable risk. Further, because it affects all assets in the market, some more and some less, it is also called market risk.
The relationship between different components of investment risk can be expressed as follows:
Total Risk (σ) = Systematic Risk (β) + Unsystematic Risk
Following are a few events that are source of systematic risk:
- Any major central bank action: reducing or raising policy rate, open market operations, etc.
- Bankruptcy of any institution critical to smooth functioning of financial market and economy. Let us say failure of another Lehman Brothers or AIG, etc.
- Wars, earth quakes, tsunamis, etc.
- Major fiscal policy changes such as new tax legislation, reduction or increase in tax rates and incidence.
- Major trade war or currency war.
- Inflation or hyperinflation
Measurement of Systematic Risk
Beta coefficient is a measure of systematic risk. A higher beta coefficient means higher systematic risk and vice versa. A beta coefficient of 1 means that the investment has systematic risk equal to the average systemic risk of the whole market.
Beta coefficient is estimated by regressing the return on an investment on the return on broad market index such as S&P 500.
Systemic risk of a portfolio is estimated as the weighted average of the beta coefficients of individual investments.
The capital asset pricing model estimates required return on an equity investment with reference to its inherent systematic risk. The higher the beta value, the higher will be the required return and vice versa as evident from the formula below:
Required Return = rf + β × (rm - rf)
rf is the risk-free rate, rm is the return on the broad market index, say S&P500 and β is the beta coefficient.
The risk that is compensated through increased return is called priced risk. Unsystematic risk is not price in CAPM because it can be fully diversified.
Management of Systematic Risk
While systematic risk cannot be diversified, i.e. it cannot be eliminated by adding more assets to a portfolio, it can be reduced through efficient asset allocation.
Let us say a portfolio consists of equities, bonds, real estate, and gold. It has lower systematic risk than an all-equity portfolio or all-bond portfolio. This is because certain systematic risk factors affect different assets classes differently. For example, a slowdown in the equity market may trigger positive return for gold. In such situation, a well-rounded portfolio which consists of different investment classes has lower overall systematic risk exposure.
Another approach is to use hedging strategies to reduce and eliminate systematic risk. For example, a hedge fund with investments in equity investments may short sell the broad market index. The negative position in the broad market index may cancel out the systematic risk that results from positive position in individual equity investments.