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:
- 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.
- 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.
- 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.
- 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: 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).