Systematic and Specific Risk

While dealing in stock markets, investors face equity price risk which arises from the volatility in the stock prices. While talking about price volatility, it is important to differentiate between systematic risk and unsystematic risk.

Systematic risk refers to the risk due to general market factors and affects the entire industry. It cannot be diversified away.

The unsystematic risk or specific risk is the risk specific to a company that arises due to company-specific characteristics. According to portfolio theory, this risk can be eliminated through diversification.

Systematic Risk

Systematic risk is due to conditions in a certain market. This could be economic, geographical or political and is also known as market risk.

There are various approaches to assessing market risk.

We can evaluate how sensitive the company’s profits are to changes in interest rates, forex rates, commodity rates, and equity prices.

The market risk of an institution is determined by its size, risk profile and complexity. It is crucial to measure, quantify, and control exposure to risk.

The type and complexity of market risk exposure matter in trading, overseas operations, and non-trading positions.

There are 4 types of market risk:

  1. Interest risk: if the central bank of a country moves its rate up or down it impacts the prices of assets. The change in interest rates leads to changes in the level of investment and how consumers spend.
  2. Equity price risk: General market conditions impact different industries in a country and therefore the stock price. This type of risk is due to macro factors.
  3. Exchange rate risk: A change in currency exchange rates affects traders who are dealing in international forex markets. The change in currency rate either increases or reduces the cost of assets.
  4. Commodity price risk: Seasonal, political and regulatory changes impact the price of commodities. This in turn affects investors, traders and producers alike. Commodity prices, directly and indirectly, affect asset prices, since they are the origin of most derived products as well.

Measurement of Systematic risk

Systematic risk is measured using two methods:

Value at Risk Method: Value-at- Risk (VaR) is a general measure of risk developed to equate risk across products and to aggregate risk on a portfolio basis. VaR is defined as the predicted worst-case loss with a specific confidence level (for example, 95%) over a period of time (for example, 1 day).

Beta Measure: To calculate the beta of a portfolio, you need to first calculate the beta of each stock in the portfolio. Then you take the weighted average of betas of all stocks to calculate the beta of the portfolio.

Hedging Systematic Risk

Since systematic risk is not diversifiable, traders try to hedge the risk by using different methods.

Options Trading: Options give buyers the right to buy or sell the underlying asset. They are under no obligation to do so by the expiration date.

Delta hedging: Delta is the first derivative of the option price with respect to the stock price, while gamma is the second derivative. So, we can define Delta as the change in the price of the option with the change in the stock price.

Futures contracts: A contract between two parties to buy or sell an underlying asset at a future date and price.

Investors can use short- or long-term hedging to safeguard their investments and counteract various market risks. Having a solid understanding of the geopolitical and economic environment of the markets an investor is investing in is beneficial in addition to these other strategies.

Specific Risk

A risk that is associated with a particular firm or industry but not the market as a whole is called a specific risk. By diversifying the portfolio, specific risks can be minimized.

Business risk and financial risk can both lead to firm-specific risk. Business risk is the risk that a company confronts as a result of intense competition, high taxes, and restrictive government regulations. Both internal and external risks are possible. Internal operational, technological, or labor-related variables might create risk. Economic or political variables might put a company at risk from outside sources.

When a company cannot adhere to its debt covenants, there is financial danger.

Reducing Specific Risk

Since the risk is specific to a firm or industry, a remedy to reduce specific risk is a highly diversified portfolio in different industries. There is a risk in holding a portfolio but in a diversified portfolio, the risk is reduced since all sectors will not have an industry issue at the same time. This reduces the volatility of the portfolio.