What is the systematic risk of investments?

Companies and investors face different kinds of risks that affect their profit or returns on their investment. The systematic risk is the risk caused due to macroeconomic factors affecting the economy that cannot be controlled by either the companies or investors. As a result of this risk, the returns which are earned from investments that are risky will fluctuate. Some factors which affect the profit of a business can be controlled by the business and its management to some extent and are the unsystematic risk of doing business. These factors include labor disputes and mismanagement for a company. The total risk involved for investors can be categorized into unsystematic risk and systematic risk. Let us define systematic and unsystematic risk in finance.

Systematic risk factors are usually macroeconomic factors such as inflation, changes in interest rates, fluctuations in currencies, recessions, or some factors as wars, corona pandemic, etc. The best example of a systematic risk example that individual companies cannot control is the 2019–20 coronavirus pandemic.

Systematic Risk explained

Many unexpected events occur regularly which cannot be controlled by the investors and these are the systematic risk of doing business, investing. This risk can be only avoided by avoiding any investment which is risky. In reality, this is not a viable option for most investors since the only investment options available to them, in this case, would be the CDs and T-bills of government-related organizations. Hence every investor should be prepared to consider these systematic risks while deciding their strategy for investment if they want good returns.

To compensate for the systematic risks while investing, most investors will expect a premium on their risky investments. To explain with an example, if a 5% return is offered for a T-bill which is risk-free, the investor will expect 10% returns while investing in shares. The investor hopes that the additional 5% return on shares will compensate for the systematic risk he is taking while investing in shares. Due to macroeconomic factors, the investor can also make a loss on his share investment and this is why he tries to get better returns.

Systematic risk should be considered the opportunity cost of choosing a particular investment when less risky options are available. Investors consider their personal choices and also financial goals while choosing their investment options. For a T-bill with a 3% return, though the returns are low, there are no systematic or other risks for the investor. On the other hand, for a stock offering 15% returns, it is possible that the investor will lose his money, and there is also the opportunity cost which should be considered when he chooses this option compared to the low-risk option of T-bill.

It is usually not possible for investors to avoid all systematic risks if they wish to get good returns. However, they can reduce the systematic risk involved by diversifying the investment. This ensures that even if they make a loss from one investment, the profits from other investments will compensate for the loss. Additionally ensuring that resources are utilized properly and procedures are followed to ensure that only quality investments are chosen, can greatly reduce the risk involved. When a company is being sold, it is important to consider the systematic risk involved since the buyer will be willing to pay a lower amount for the business to compensate for the risk involved in the deal.

Managing Systematic Risk and Unsystematic Risk

Investing money is risky, the investor may lose some of their money. Experts believe that the greatest risk for investors is losing their capital amount permanently. Hence to avoid losing their capital completely, investors have to adopt a strategy for managing the risk for their investment portfolio. For this, they will have to understand how unsystematic and systematic risk will affect their portfolio. They will also have to find out the most effective way of reducing the risks involved in their investment. We can mitigate risks using Standard Operating Procedures (read article sop meaning)

Systematic risk is related to a large number of factors affecting the entire investment market, it is not related to a specific risk related to a particular investment. Changes in the bank and other interest rates, inflation, fluctuation in currency exchange rates, wars, recession are some of the macroeconomic factors that affect the systematic risk. These macroeconomic factors affect both the direction in which the market moves and the volatility. The systematic risk cannot be controlled by a single company or individual.

Asset allocation is widely used to reduce the systematic risk involved to some extent. Since the value of asset categories will change in a different manner to changes in macroeconomic data, investors can reduce the volatility in their portfolio by investing in asset classes with a low correlation to each other. When the value of some asset categories like domestic equities, stocks, are increasing, others like bonds, cash will decrease in value, and vice versa to reduce volatility. Experts also believe that they should consider the value of the assets while investing. They should invest more in bargains, and avoid investing in assets that are considered overpriced. To reduce systematic risk, they should also invest in cash which is often not appreciated.

Unsystematic Risk

Risk which is specific to a company or industry is considered an unsystematic risk. This risk can be attributed to a specific investment or investment group. It is not linked to the returns from the stock market. It also called the diversifiable, residual, or specific risk. These risks can be controlled to some extent by the industry sector or company. These risks are divided into financing, business, credit, product, legal, liquidity, political and other risks. Unsystematic risk can be almost completed eliminated by diversification. The investor with only one stock or bond will suffer great losses if there is a problem with the stock. On the other hand, if the investor has a diversified portfolio of 40 different investments, the losses to problems in a particular stock will affect the portfolio less.

Probability, Expected Portfolio Value

For calculating the expected value of a portfolio, the possible returns and probability of each return will be considered. One way to measure risk is determining the deviation and how the probability of the deviation compares with the expected returns. Diversification reduces the unsystematic risk and portfolio risk is mitigated by allocating assets properly. Mitigating risk ensures that the portfolio manager has more profitable assets with higher risks resulting in portfolio optimization. The portfolio manager can handle a specific amount of risk and if the systematic and unsystematic risk are lowered, he can opt for investments offering higher returns.

Systemic vs. Systematic Risk: What’s the Difference?

In order to understand systemic vs. systematic risk both of these terms a bit more closely. If an event causes a major setback to an economy or a particular industry then it is known as a Systemic Risk but if the market experiences a consistent and everlasting risk for an extended time due to a number of reasons then it is known as Systematic Risk. The information provided in this write-up will help you in understanding the basic differences in these two terms.

Difference between systemic risk and systematic risk

Systemic risk can give a complete shock to the system from outside whereas the shock provided by the systematic risk based on a number of factors can be ongoing and on a day-to-day basis. For instance, the financial crisis of 2008 that has triggered massive implosion in the world market was based on the threat of failure of one of the major banks of the US. It is a good example of systemic risk. The risks based on the changes in interest rates, corporate health, geopolitical issues, etc. are some of the examples of systematic risk.

Moreover, it is hard to predict and scale the systemic risks whereas in some cases it is easier to predict and scale systematic risks

Systemic risk can be defined as the risk related to the complete breakdown of a sector, industry, financial institution, business, financial system or the entire economy. Some of the small but particular problems like leakage of information of website users or flaws in the security of bank accounts etc. can also come in the category of systemic risks. In other words, systemic risk can be defined as a substantial danger occurred in a company that can widely influence the entire financial system.

Systematic Risk, on the other hand, is not easy to define as it is a bit vague. In simple words, it can also be used as the term market risk’ which involves the dangers faced by the entire market and is not easy to resolve even if you spread your holding into several branches. The basis of such widespread risks for the market can be the period of weakness or recession in the economy, decline or rise in interest rates, wars, fluctuations in the prices of the commodities or currencies, etc. However, the systematic risk can be managed but cannot be eliminated by following the strategy of allocating the assets in different ways.

Some examples of systemic vs systematic risks

In 2008, the failure of Lehman Brothers that has affected the entire economy and financial system is one of the most recent examples of systemic risk. This failure has caused a domino effect on the financial system of the entire world because Lehman Brothers was a big company. The government has to intervene to resolve this problem.

One of the latest examples of systematic risk is the economic recession faced by the entire world in the late 2000s. at that time, people who have invested in the market, have seen drastic changes in the value of their investments due to this economic crisis. The assets of different classes were affected differently due to this recession.

Thus, systemic risks are basically different from systematic risks.

Bid and ask meaning in forex

There are different types of securities that can be traded in a financial marketplace. In the case of the forex market, the currencies of different countries and the forex rates are the securities that are traded in the market. In financial markets, especially the forex market, most buyers and sellers like businesses and investors will not interact with each other directly. Instead, the trades in securities like forex will be routed through intermediaries like traders and dealers who will purchase and sell the security on behalf of their client.

Since the traders and dealers are taking a risk in purchasing and selling the forex, there is likely to be a difference in the value of prices at which the security will be purchased and sold. Typically a forex trader will offer a lower price for a currency if he is purchasing it and sell it at a higher price to the currency buyers to compensate for the risk he is taking when investing his money in the currency at a particular time. Hence those who are dealing in forex should be aware of the bid and ask meaning in forex since these terms are used frequently by those selling and buying forex.

Bid price

The bid price in forex is the maximum exchange rate which a forex trader is willing to pay for the currency pair. The forex buyer will always be interested in paying the lowest price for the currency he wishes to purchase and will specify the lowest bid price. This bid price will be considered by forex traders, who wish to sell the specified currency. However, the currency will only be purchased when the currency buyer is able to find a seller who is willing to match his bid price. If the buyer is unable to find a seller, matching his bid price, he may have to increase it.

Ask price

Ask price is the lowest price that the forex dealer or trader is willing to sell the currency for. Often the forex dealer is acting on behalf of a business that is selling a particular currency which it has received as payment for a product or service sold. The dealer will usually look at the bid price of the currency to set the asking price. A deal will be finalized when the forex dealer finds a trader willing to pay the asking price. Though the dealer would want to maximize his profit, setting the asking price high as possible, he will find it difficult to find a buyer for currency, if the price is much higher than the market rate.

Bid and ask price foreign exchange example
Here are below bid, ask price , spread example:

Understanding the bid, ask price

The bid and the ask price are important for those who wish to deal in forex since they provide an indication of the rates at which a transaction is likely to get finalized. The forex trader who wishes to purchase currency will find that he is paying a price which is higher than the current selling price of the currency since there are transaction costs involved for every trade. The information about the bid and ask prices provided by the various forex traders and dealers are used by the forex buyer or seller to choose the trader or dealer who is offering the best possible price.

The asking price, the bid price is an indication of the transaction cost which a person will incur if they purchase a currency and sell it immediately. The bid and ask price will also depend on the economy of the country, financial stability. In some countries, the inflation rates are high, and the currency value is decreasing rapidly. In these cases, forex traders will find it difficult to find buyers for the currency of the country. Hence if they are investing in this currency, they will usually keep the asking price higher.

Spread

The difference between the bid and the asking price for a particular currency pair is called the forex spread or bid-ask spread. It is an indication of the market liquidity, how easy or difficult it is for a seller to find a buyer who is willing to pay the price he requires. When there is a lot of liquidity in the market, the spread will be low, and when there is less liquidity in the market, the spread will be higher. Typically when forex markets are open, the spread for major currency pairs like the USD/Euro will below. On weekends, major forex dealers are closed, reducing the liquidity in the market and the spread will also be higher.