Systematic and Unsystematic Risk of a Business

By

Subject: Financial Management

Indian Institute of Planning & Management

New Delhi

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 Abstract

The Vast majority of traditional research in finance appears to be biased towards the
financial control and management of established businesses. The reference to new
venture creation and start-ups are conspicuously absent from the literature. This is
more obvious in its treatment of risk in traditional finance literature. The
identification, measurement and management of risk are based on the so-called
notion of ‘systematic risk’ (or market risk) only, measured by the ‘Beta’ of investment
returns. The accepted wisdom in finance is that market volatility is the main concern
in making investment decisions. Company and industry specific risk is trivial because
such risk could be eliminated through sufficient diversification of investment
portfolio across the market. This paper argues that this paradigm of the portfolio
theory is, by and large, inappropriate for research in entrepreneurial finance, where
life is complex, more unpredictable and perhaps chaotic. In the world of start-ups and
new venture creation, a business may not already exist, the entities may not be a
player in the so called capital market, and the venture capital suppliers may not have
the luxury of relying on quoted market prices to guide them. Consequently, the firm
specific (and therefore neglected) ‘unsystematic’ risk becomes more critical.
Unfortunately the body of research in this area is not huge. The discipline relies
heavily on intuition, gut feeling, anecdotal evidences, and admittedly, luck. This
paper highlights the deficiencies of the traditional finance theories in dealing with
risk in a venture Capital (VC) investment decisions. It attempts to explore the venture
capital investors’ risk assessment and management techniques vis-à-vis the investors’
perception of risk. The objective is to identify key risk parameters and establish some
cause and effect relationships between those variables. The paper suggests that
instead of an all purpose model, a number of risk assessment tools are needed for
assessing investment proposals at various stages in the life cycle of a business.

2
 Project Approval

From: iipm reexamination <iipmreexamination@gmail.com>

Date: Tue, Jan 6, 2009 at 10:38 AM

Subject: projects topic
To: puneet.chauhan@gmail.com

Dear puneet

I am giving you the project which approved by sumanto sir. Also I am sending you the
guideline of the project. So before doing the project please read it very carefully and then
do the project according to the guideline.

Production:-
Study production planning and control procedures in a manufacturing company and
identify the strength and weaknesses with the suggestion to improve.

modern economic thoughts:-

price cutting strategy and its effect on industry

cesd:-
Impact of subprime crisis on Asian Economies

company law:-
Corporate governance, practice and breakdown. Choose any company of your choice and
substantiate the above statement.

micro economic:-
Price ceiling & Price floors, Price rigidity under oligopoly, Extent of market, Changing
market conditions.

financial mgmt:-
Systematic and unsystmatic risk of a business

Best regards
S.K. Maidul Islam
IIPM, Satbari
Chandan haula
Bhatimines road
New Delhi-74

3
011-42789877
www.iipm.edu

ACKNOWLEDGEMENT

I would like to express my gratitude to all those who gave me the possibility to
complete this project. I am deeply indebted to my supervisor Prof. Sumanto from
the Indian Institute of Planning & management whose help, stimulating
suggestions and encouragement helped me in all the time of research for and
writing of this project.

I am obliged to my friend Richa Singh from Ericsson India Pvt Ltd who supported
me in my research work. Also, I would like to thank Amit Jain from Ernst &
Young for all his assistance looked closely at the final version of the project. I
want to thank them for all their help, support, interest and valuable hints.

Especially, I would like to give my special thanks to my wife Preeti Jain whose
patient love enabled me to complete this work.

4
 Table of Contents

S.no Content Page No.

1 Introduction 6
2 What is systematic risk and unsystematic risk 6
3 Systematic and Unsystematic risk of a Business 9
4 Sharpe's Single Index Model 10
5 Definitions of Systemic Risk in Banking 11
6 Dangers of Systemic Risk 13
- Failure Chains 20
- Common-Shock or Reassessment Failures 21
7 Risk Management & Contingency Estimating 23
8 Monte Carlo based Contingency 24
9 Effects Of Systemic Risk Drivers 25
10 Confusing Cost Drivers With Risk Drivers 26
11 Probabilities, Ranges & Contingency Estimating 26
12 Driver-Based Methods: A Better Approach 27
13 Driver-Based Contingency Models In Industry 28
14 Contingency Estimating Model 29
15 An Integrated Approach 30
16 The Risk Pyramid 30
- Risk-Reward Concept
- Determining Your Risk Preference
- Personalizing the Pyramid
Systematic Risk and Unsystematic Risk (Finance &
17 Investments) 32
18 Capital Asset Pricing Model 33
- The formula
- Risk and diversification
- The efficient frontier
- The efficient frontier
- The market portfolio
19 Assumptions of CAPM 36
20 Shortcomings of CAPM 36
21 Risk of Rate of Return associated 38
22 Sources of Systematic vs. Unsystematic Risk 40

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 23 Risk and Diversification 42
- What Is Risk
- Different Types of Risk
- The Risk-Reward Tradeoff
- Diversifying Your Portfolio
24 Preventing Unsystematic Risk 48
25 Conclusion 49
26 Bibliography 50

Introduction

What is systematic risk and unsystematic risk?

Systemic Risk

Systemic risk refers to the risk or probability of breakdowns in an entire system, as

opposed to breakdowns in individual parts or components, and is evidenced by
comovements (correlation) among most or all the parts. Thus, systemic risk in
banking is evidenced by high correlation and clustering of bank failures in a single
coun- try, in a number of countries, or throughout the world. Systemic risk also may
occur in other parts of the financial sector—for example, in securities markets as
evidenced by simultaneous declines in the prices of a large number of securities in
one or more markets in a single country or across countries. Systemic risk may be
domestic or transnational.

It is the risk which is due to the factors which are beyond the control of the people
working in the market and that's why risk free rate of return in used to just compensate
this type of risk in market.

Unsystematic Risk

Unsystematic Risk, is that company or industry specific risk that is inherent in each
investment one makes. The amount of unsystematic risk present can be eradicated through
appropriate diversification. For example: Suppose you have $100,000 to invest, and you
put it all into a single biotechnology company. The company, say X Inc, suffers a major
setback in one of its experiments, and goes into huge losses. This event, is company
specific, and reduces your wealth. However, if one invests $10,000 in 10 different
biotechnology companies, the probability of wealth reduction due to unforeseen events or
setbacks is reduced considerably. Also known as "specific risk", "diversifiable risk" or

6
"residual risk", this risk can be defined as that part of a risk which is not correlated with
general market movements.

This is the risk other than systematic risk and which is due to the factors which are
controllable by the people working in market and market risk premium is used to
compensate this type of risk.

Total Risk = Systematic risk + Unsystematic Risk

 Systematic vs. Unsystematic Risk

 All risky assets have both types of risk.

 Systematic Risk (market risk) ECONOMYWIDE. Influences a large number of

assets simultaneously

 Wars

 Inflation

 Interest rate changes

 Unsystematic risk (idiosyncratic risk, unique risk)

Only influences a small number of assets or individual asset

 Systematic vs. Unsystematic Risk

 A company’s technical wizard is killed in a car accident (systematic/unsystematic)

 Long-term interest rates rise significantly (systematic/unsystematic)

 OPEC institutes an oil embargo (systematic/unsystematic)

 The price of Japanese sake drops by 60% (systematic/unsystematic)

 Fed proposes another interest rate cut (systematic/unsystematic)

 Note that the risk can include good things happening as well as bad things
happening.

Investments have two components that create risk. Risks specific to a particular type of
investment, company, or business are known as unsystematic risks. Unsystematic risks
can be managed through portfolio diversification, which consists of making investments
in a variety of companies and industries. Diversification reduces unsystematic risks

7
because the prices of individual securities do not move exactly together. Increases in
value and decreases in value of different securities tend to cancel one another out,
reducing volatility. Because unsystematic risk can be eliminated by use of a diversified
portfolio, investors are not compensated for this risk.

Systematic risks, also known as market risk, exist because there are systemic risks within
the economy that affect all businesses. These risks cause stocks to tend to move
together, which is why investors are exposed to them no matter how many different
companies they own.

Investors who are unwilling to accept systematic risks have two options. First, they can
opt for a risk-free investment, but they will receive a lower level of return. Higher
returns are available to investors who are willing to assume systematic risk.
However, they must ensure that they are being adequately compensated for this risk.
The Capital Asset Pricing Model theory formalizes this by stating that companies desire
their projects to have rates of return that exceed the risk-free rate to compensate them
for systematic risks and that companies desire larger returns when systematic risks
are greater.

The other alternative is to hedge against systematic risk by paying another entity to
assume that risk. A perfect hedge can reduce risk to nothing except for the costs of
the hedge.

Unsystematic risk refers to all risks associated with investing in a company. When you
buy shares of a company in the stock market, you are assuming all the risks that this
company faces. Unsystematic risk associated with investing in a company includes:
risk of losing a key senior management personnel to death, risk of losing the market
leadership position, risk of fire and damage to the property, risk of a substitute
product, and risk of product recall. Unsystematic risk is unique to this company in an
industry. For example, the risk of product recall is higher for food manufacturing
company than tissue paper manufacturing company.

The risk of a plane crashing is unique to the airline industry. The risk of a plane
crashing does not apply to food manufacturing company.

When unsystematic risk happens to a company, the share price of this company will fall
drastically. If the investor invests solely in this company, he will lose money when
any unfortunate event happens to this company.

Diversification helps to diversify away unsystematic risk. When the investor has
more than thirty stocks in his portfolio, and all the stocks come from different sectors,
he has diversified away the unsystematic risk. Anything happens to one company is
not likely to wipe out his entire portfolio.

Systematic risk refers to the risks face by the entire stock market and cannot diversify
away. Changes in the macroeconomics factors affect the systematic risk. Systematic
risk is the risk affecting the entire stock market.

8
 In a recession, the prices for most companies in the stock market will come
down. Recession is an example of systematic risk affecting the stock market.
Mutual funds and index funds are diversified portfolios subjected to systematic risk
of the stock market. Fund managers do not have the power to reduce systematic risk.
Even the governments of the world, however powerful they are, cannot stop the
country from going into recession.
Fund managers can only mitigate risks, so that the portfolios do not suffer such a
heavy
Diversification is still the way to reduce risks in the stock market investment. No matter
how you participate in the stock market investment, you have to diversify. You cannot
afford to assume both systematic risk and unsystematic risk in the stock market
investment.

Systematic and Unsystematic risk in a Business

"Sometimes your best investments are the ones you don't make." This is a maxim which
best explains the complexity of making investments. There are many investment avenues
available for investors today. Different people have different motives for investing. For
most investors their interest in investment is an expectation of some positive rate of
return. But investors cannot overlook the fact that risk is inherent in any investment. Risk
varies with the nature of return commitment. Generally, investment in equity is
considered to be more risky than investment in debentures & bonds. A closer look at risk
reveals that some are uncontrollable (systematic risk) and some are controllable
(unsystematic risk). Risk can be categorized into two types:

The risk that cannot be diversified away like interest rate risk and recession is known as
systematic risk. Unsystematic risk is stock specific and can be diversified away. Scarcities

9
in raw material supply, labour strike, and management inefficiency are all problems
specific to a company and are internal in nature. These negative factors can make the
share price fall sharply but can be avoided if well thought. An investment in the shares of
certain other companies with sound management can help minimize this risk. Therefore
diversification is the mantra for any prudent investor. Diversification is done in many
ways. Investors can diversify across one type of asset classification - such as equities or
among different asset classes such as stocks, bonds, fixed income and bullion etc. But the
question to be answered is: How many stocks help diversify unsystematic risk? Theory
suggests that 18-20 stocks in a portfolio helps to reduce unsystematic risk. But again,
tracking 18-20 stocks becomes cumbersome for investor. Whatever be the number of
stocks, it is an undeniable fact that Diversification helps reduce unsystematic risk. This
paper stands to investigate the effect of diversification on unsystematic risk by applying
Sharpe's Single Index Model and also analyzes the relationship between return & risk.

Sharpe's Single Index Model

The major assumption of Sharpe's single-index model is that all the covariation of security
returns can be explained by a single factor. This factor is called the index, hence the name
"single-index model." One version of the model, called the market model, uses a market
index such as the BSE Sensex as the factor (any factor that influences security returns can
serve as the index).
Methodology used.
The data consists of daily closing prices of BSE- Sensex for the period from April 2006 to
March 2007. For study purpose, inorder to calculate Return on stock, Return on market
index (BSE Sensex), and Expected Return on securities and portfolios it is assumed that
market will give 15 percent annual return.
Portfolio Return and Risk

TABLE

Portfolio Stocks Var.st B1 Alpha Syst. rick Unsy- Cor.Co. (1-R2) Exp. Ret.
B1 2ox2 stam atic eff. R2 E(R)
ei2
P1 15 2.75 0.88 -.02 .02 2.72 0.47 0.53 0.13
P2 15 3.14 1.12 -0.05 0.04 3.10 0.56 0.44 0.14

The above table shows the statistical summary of two portfolios constructed on the basis
of beta value of thirty stocks. P1 is low market risk portfolio and high market risk
portfolio is P2. Total risk of P1 is low as compared to P2. The expected return is
consistent with its market risk. If invested in P1 can realize 13% annual return whereas
investment in P2 offers 14% annual return. Therefore it is evident that with diversification
as a tool unsystematic risk can be minimized. As per the investor's risk appetite portfolio
can be constructed. To conclude, several vaccinations are needed to protect one's
portfolio from vagaries of market. "DIVERSIFICATION" which is much talked about but

10
seldom practiced can be the right tool for any investor. So all investors in order to counter
unsystematic risk vaccinate your portfolios with diversification.

Definitions of Systemic Risk in Banking

The precise meaning of systemic risk is ambiguous; it means different things to different
people. A search of the literature reveals three frequently used concepts. The first
refers to a “big” shock or macroshock that produces nearly simultaneous, large,
adverse effects on most or all of the domestic economy or system. Here, systemic
“refers to an event having effects on the entire banking, financial, or economic
system, rather than just one or a few institutions”.

Likewise, Frederic Mishkin defines systemic risk as “the likelihood of a sudden, usually
unexpected, event that disrupts information in financial markets, making them unable
to effectively channel funds to those parties with the most productive investment
opportunities” (1995, 32). How the transmission of effects from a macroshock to
individual units, or contagion, occurs and which units are affected are generally
unspecified. Franklin Allen and Douglas Gale (1998) model one process through
which macroshocks can ignite bank runs.

The other two definitions focus more on the microlevel and on the transmission of the
shock and potential spillover from one unit to others. For example, according to the
second definition, systemic risk is the “probability that cumulative losses will accrue
from an event that sets in motion a series of successive losses along a chain of
institutions or markets comprising a system. . . . That is, systemic risk is the risk of a
chain reaction of falling interconnected dominos” (Kaufman 1995a, 47). This
definition is consistent with that of the Federal Reserve (the Fed). In the payments
system, systemic risk may occur if an institution participating on a private large
dollar payments network were unable or unwilling to settle its net debt position. If
such a settlement failure occurred, the institution’s creditors on the network might
also be unable to settle their commitments. Serious repercussions could, as a result,
spread to other participants in the private network, to other depository institutions not
participating in the network, and to the non financial economy generally.

11
Likewise, the Bank for International Settlements (BIS) defines systemic risk as
“the risk that the failure of a participant to meet its contractual obligations may in
turn cause other participants to default with a chain reaction leading to broader financial
difficulties” (BIS 1994, 177). These definitions emphasize correlation with causation,
and they require close and direct connections among institutions or markets.

When the first domino falls, it falls on others, causing them to fall and in turn to knock
down others in a chain or “knock-on” reaction. Governor E. A. J. George of the Bank
of England has described this effect as occurring “through the direct financial
exposures which tie firms together like mountaineers, so that if one falls off the rock
face others are pulled off too” (1998, 6). For banks, this effect may occur if Bank A,
for whatever reason, defaults on a loan, deposit, or other payment to Bank B, there by
producing a loss greater than B’s capital and forcing it to default on payment to Bank
C, thereby producing a loss greater than C’s capital, and so on down the chain
(Crockett 1997). Banks, especially within a country, tend to be connected closely
through interbank deposits and loans. Note that in this second definition, unlike in the
first macroshock definition, only one bank need be exposed in direct causation to the
initial shock. All other banks along the transmission chain may be unexposed to this
shock. The initial bank failure sets off the chain or knock-on reaction.

The smaller a bank’s capital-asset ratio—the more leveraged it is—the more likely it is
that it both will be driven into insolvency by insolvencies of banks located earlier on
the transmission chain and will transmit losses to banks located later on the chain.
What makes direct-causation systemic risk in financial sectors particularly
frightening to many is both the lightning speed with which it occurs and the belief
that it can affect economically solvent (innocent) as well as economically insolvent
(guilty) parties, so there is scarcely any way to protect against its damaging effects.

A third definition of systemic risk also focuses on spillover from an initial exogenous
external shock, but it does not involve direct causation and depends on weaker
and more indirect connections. It emphasizes similarities in third-party risk exposures
among the units involved. When one unit experiences adverse effects from a shock—
say, the failure of a large financial or nonfinancial firm—that generates severe losses,
uncertainty is created about the values of other units potentially also subject to
adverse effects from the same shock. To minimize additional losses, market
participants will examine other units, such as banks, in which they have economic
interests to see whether and to what extent they are at risk. The more similar the risk-
exposure profile to that of the initial unit economically, politically, or otherwise, the
greater is the probability of loss, and the more likely it is that participants will
withdraw funds as soon as possible. This response may induce liquidity problems and
even more fundamental solvency problems. This pattern may be referred to as a
“common shock” or “reassessment shock” effect and represents correlation without
direct causation (indirect causation).
Because information either on the causes or the magnitude of the initial shock or
on the risk exposures of each unit potentially at risk is not generally available
immediately or accurately and is not without cost, and because analysis of the

12
 information is not immediate or free, participants generally require time and
resources to sort out the identities of the other units at risk and the magnitudes of any
potential losses.
Moreover, in banking, as credit markets deteriorate, the quality of private and public
information available also deteriorates as the cost of accurate information increases
and as uncertainty increases further. Because many of the participants are risk averse and
would rather be safe than sorry, they quickly will transfer funds, at least temporarily
during the period of confusion and sorting out, to well-recognized safe or at least
safer units without waiting for the final analysis. In addition, in periods of great
uncertainty and stress, market participants tend increasingly to make their portfolio
adjustments in quantities (runs) rather than in prices (interest rates).1 That is, at least
temporarily, they will not lend at almost any rate. Thus, there is likely to be an
immediate flight or run to quality away from all units that appear potentially at risk,
regardless of whether further and more complete analysis might identify them ex post
as having similar exposures that actually put them at risk of insolvency. At this stage,
common-shock contagion appears indiscriminate, potentially affecting more or less
the entire universe and reflecting a general loss of confidence in all units. Solvent
parties are not differentiated from insolvent. Because these runs are concurrent and
widespread, such behavior by investors is often referred to as “herding” behavior.

The runs are likely to exert strong downward pressure on the prices (upward
pressures on interest rates) of the securities of affected financial institutions and markets.
Any resulting liquidity problems are likely to spill over temporarily to banks not
directly affected by the initial shock. Thus, the initial domino does not fall directly on
other dominos, but its fall causes players to examine nearby dominos to see whether
they are subject to the same destabilizing forces that caused the initial domino to fall.
Broad contagion is likely to occur during such sorting-out or reassessment periods.
At a later date, after the sorting-out process is complete, some or all of these
flows affecting solvent banks may be corrected or reversed. Nevertheless, during the
sorting-out period, the fire sale–driven changes in both financial quantities (flows)
and prices (interest rates) are likely to overshoot their ultimate equilibrium levels
because of an uncertainty discount and thus to intensify the liquidity problems,
particularly
for more vulnerable units (Kaminsky and Schmukler 1999). However, the more frequent
banking crises are, the more likely are market participants to become both better
prepared and better informed, the sorting-out and liquidity-problem periods to be
shorter, and the duration of any overshooting to be briefer.
A distinction is often made between rational or information-based, directly or indirectly
caused systemic risk and irrational, noninformation-based, random, or “pure”
contagious systemic risk (Aharony and Swary 1996; Kaminsky and Reinhart 1998;
Kaufman 1994). Rational or informed contagion assumes that investors (depositors)
can differentiate among parties on the basis of their fundamentals. Random
contagion, based on actions by uninformed agents, is viewed as more frightening and
dangerous because it does not differentiate among parties, affecting solvent as well as
insolvent parties, and therefore is likely to be both broader and more diffi cult to
contain.2 Thus, Governor George (1998, 6) of the Bank of England considers
systemic risk as exceptionally costly because “the danger that a failure of one

13
 financial business may infect other, otherwise healthy, businesses.” Direct, knock-on
contagion is perceived as knocking over solvent as well as insolvent banks on the
transmission chain. Common-shock contagion systemic risk is likely to affect solvent
banks immediately during the sorting-out period, although in time investors and
depositors will sort these banks out from the insolvent banks. Thus, the empirical
borderline between rational and irrational contagion is fuzzy and depends in part on
the time horizon applied. Likewise, the definition of solvent and insolvent is not
always clear and precise.

Solvent parties may be defined as units that are perceived widely to be economically well
behaved—that is, banks that are perceived to be economically sound and not overly
leveraged. In contrast, insolvent banks are those perceived as insolvent or solvent but
near insolvency or excessively leveraged.

Dangers of Systemic Risk

Both the chain-reaction and the common-shock concepts of systemic risk involve speedy
contagion and require some actual or perceived direct or indirect connection among
the parties at risk (Kaufman 1994). Banks are connected directly through interbank
deposits, loans, and payment-system clearings and indirectly through serving the
same or similar deposit or loan markets. In addition, to the extent that banks operate
across national borders, they link the countries in which they operate. Thus, an
adverse shock that generates losses at one bank large enough to drive it into
insolvency may transmit the shock to other banks along the transmission chain.
Moreover, adverse shocks in the financial sector appear to be transmitted more
rapidly than similar shocks in other sectors. Both theory and evidence suggest that the
probability, strength, and breadth of any contagious systemic risk are greater for
banking, the larger and more significant is the bank experiencing the initial shock. It
follows that the transmission and danger of systemic risk are likely to differ
depending on the strength of the initial shock and on the characteristics of the bank
initially affected.
In the absence of guarantees, units on the transmission chain reasonably may be expected
to attempt to protect themselves from losses caused by shocks. For banks, this
attempt requires them to charge higher interest rates on riskier investments, to
monitor their counterparties carefully, to require more and better collateral, and to
have sufficient capital to absorb any losses from their association with an infected
bank or from runs by their depositors. Jean-Charles Rochet and Jean Tirole (1996)
model such a structure. In general, for the initial shock to be transmitted successfully
and to ring down other banks, losses must exceed capital at each bank along the
chain.
Banks with sufficient capital to absorb the transmitted losses will remain solvent,
although they may be weakened, and thus will stop the cascading. The amount of
capital
required to remain solvent depends on the exposure of a particular bank to other units and
on the expectations regarding the magnitude of any shocks. Both the exposure and

14
 the expectations vary among banks and through time for any one bank. Nevertheless,
ceteris paribus, the more leveraged are the banks or other institutions, the smaller is
the adverse shock required to drive a bank or other institution into insolvency, nd the
greater is the likelihood that any losses will be passed along the transmission chain.
In addition, the faster the transmission occurs, the more difficult it is for units to
develop their protection after the shock has occurred, and the more important it is for
them to have sufficient protection in place beforehand. In these regards, the financial
sector differs from most other sectors, where the transmission of adverse shocks is
slower and units generally have time to act to protect themselves after the initial
shock has occurred.
Random contagious systemic risk is considered particularly dangerous and undesirable
because it spills over to and damages both banks that are perceived to be
economically
solvent and those that are considered insolvent. Although it is relatively easy to
distinguish the solvent from the insolvent after the crisis, it can be difficult in practice
to do so before a crisis. Ex ante information is frequently not sufficiently available,
timely, or reliable to make the distinction with much confidence. Banks, often with
the active assistance and encouragement of their governments, frequently fail to
disclose relevant information and, especially as they approach insolvency, tend to
provide insufficient reserves for loan losses and to use questionable and sometimes
even fraudulent accounting procedures to inflate their reported capital ratios.
Historical Evidence of Contagious Systemic Risk Clusterings of bank failures occur
frequently, but do they reflect systemic risk? The empirical evidence depends on the
definition of systemic risk used. Almost tautologically, systemic risk is observed most
frequently when it is defined as a big, broad shock. As noted earlier, however, this
definition is silent on the existence or transmission of contagion. Common-shock
systemic risk, particularly in the short term, appears to be more frequent than chain-
reaction systemic risk. Systemic risk, when it does occur, appears both to be rational
and to be confined primarily to “insolvent” institutions and not randomly to affect
solvent banks fatally (Kaufman 2000a).
With respect to banks, at least in the United States, there is little if any evidence of
contagious systemic risk that causes economically solvent banks to become
economically
or legally insolvent, either before or after the introduction of federal government
guarantees and insurance (Kaufman 1994). U.S. banks have been studied most
thoroughly because of their large number, good historical data, and minimum
government ownership or control. The evidence indicates that problems at one bank
or at a group of banks do spill over to other banks in general, but almost exclusively
only to banks with the same or similar portfolio-risk exposures and subject to the
same shock. There is little if any empirical evidence that the insolvency of an
individual bank directly causes the insolvency of economically solvent banks or that
bank depositors run on economically solvent banks very often or that, when they do,
they drive these banks into insolvency.

Potential Exposure

A recent study simulated the likelihood of direct causation or knock-on contagion in

15
the United States through Fed funds transactions and other interbank exposures for
the period February–March 1998 (Furfine 2003). These funds are de jure uninsured
and, since the Depositor Preference Act of 1993, are subordinated to all domestic
deposits. The study found that if a high loss rate of 40 percent is assumed, well above
average bank loss rates experienced even in the crises of the 1930s and 1980s, the failure
of the largest debtor bank in the U.S. Fed funds market would cause the economic
insolvency of only two to six other banks holding less than 1 percent of total bank
assets. The failure of smaller debtor banks would have lesser effects. If the two largest
debtor banks failed at the same time, fewer than ten other banks would fail. All other
banks held sufficient capital to absorb the losses. If the assumed loss rate were reduced
to 5 percent, approximately that experienced in the Continental Illinois Bank failure
in 1984, no other banks would fail.

The results did not change much when total interbank exposures were simulated.
The simultaneous failure of the largest two debtor banks causes more than fifteen
other banks with more than 3 percent of total bank assets to fail only when the
loss rate exceeds 65 percent. Such a loss rate would be exceedingly high for large
resolved banks in the United States. Even at the height of the banking crises in the
1980s, when regulators regularly forbore and delayed resolving insolvencies until
after significant runs by uninsured depositors effectively had stripped the banks of their
best assets and had increased losses as a percent of the remaining assets, the losses at
large commercial banks rarely exceeded 10 percent of assets (Kaufman 1995b). At
these loss rates, Furfine’s (2003) simulations predict only minor knock-on effects.
Moreover, these results overstate the damage to other banks because they assume
failure when only tier 1 (basically equity capital), rather than total capital, including
tier 2 (basically subordinated debt and limited loan-loss reserves), is depleted.
Similarly, simulation studies of the Swiss and Italian domestic interbank markets also
report a relatively small “threat to financial market stability” from default by one
bank (Angelini, Maresca, and Russo 1996; Sheldon and Maurer 1998).

Dealing with Systemic Risk

In light of the foregoing discussion of theory and evidence, how should bank regulators
and supervisors deal with systemic risk? The preceding analysis clearly indicates that
private-market incentives can and do play a major role in limiting systemic risk and
that the government should always be highly sensitive to whether its actions are
undermining or reinforcing the private mechanisms (Kaufman 1996). The latter is
especially important in relation to the design and use of various safety-net measures.
The issues, however, are not easy ones, and it is useful to undertake a normative
analysis in terms of the three not mutually exclusive definitions of systemic risk set
forth earlier.
Macroshock If asset or currency values drop sharply and affect a nation’s entire economy,
banks will not be immune. Indeed, history has shown them to be particularly
vulnerable because debtors default and collateral depreciates. The most recent

16
 example is the banking and currency crises that hit Indonesia, Korea, Malaysia, and
Thailand in 1997.

All banks will incur losses in severe depressions or when asset bubbles burst; weaker
banks will become insolvent, and failures may spread beyond them.
By far the most important contribution any government can make to preventing
macroshocks and their effects is to avoid adopting monetary and fiscal policies that
produce them or to introduce policies that moderate them. Such policies lie beyond
the scope of this article. It should be noted, however, that many countries have small,
undiversified economies highly vulnerable to external disruptions that they have little
or no ability to control or offset (Brock 1992). In this article, we take as given the
occurrence of macroshocks for whatever internal or external reasons.

To protect themselves against such contingencies, banks employ various risk management
techniques, including the maintenance of higher capital ratios to absorb unexpected
losses. It is difficult, however, to anticipate the probability and magnitude of extreme
events and hence the amount of capital that an individual bank, given its risk
preferences, ought to maintain. Indeed, in most countries, banks do not even need to
try to protect themselves against “one in a hundred years” events because their
governments have adopted de jure or de facto deposit insurance or other guarantee
arrangements that in large part free the individual bank from pressure by depositors at
risk and that substitute regulatory capital requirements for market requirements. The
evidence indicates that macrofailures (as opposed to individual bank failures) usually
arise more from shortcomings in government monetary, fiscal, or regulatory policy
than from shortcomings in bank management. Hence, the cost of those shortcomings
is placed more appropriately on the government than on the bank or on its depositors
(Scott and Mayer 1971). Nevertheless, the bank’s and depositors’ responses to
damaging government policies are likely to exacerbate risk taking, the fragility of the
financial sector, and the magnitude and damage of the macroshock (Crockett 2000).
For example, federal deposit insurance has proved effective in stopping bank runs in the
United States and in blocking that avenue of contagion spread—but at a price.
The evidence indicates that deposit insurance is associated with an increase in the costs of
the initial insolvencies in two ways (Gupta and Misra 1999). First, institutions were
relieved of whatever market discipline might have been exerted by insured claimants.
If the deposit insurance is underpriced, as is not uncommon, it contributes to a
moralhazard problem in which bank management is induced to take on greater risk.
Second, bank supervisors have strong incentives to delay recognition of insolvencies
and
payment for their losses. In any political regime, it is advantageous to defer costs beyond
one’s term in office, if possible. As recognition and resolution are delayed, losses are
likely to grow rapidly. Incumbent management, if left in control, has every reason to
take high-risk (and even negative present-value) investments, and government
liquidators have limited expertise and weak incentives to maximize profits.

17
The undesirable side effects of deposit insurance have produced efforts to counteract them
by regulation. The FDIC Improvement Act (FDICIA) of 1991 changed a flat-rate
deposit-insurance assessment fee to a risk-related premium system to deal with the
moral-hazard problem, and it instituted a “trip-wire” scheme of prompt, statutorily
mandated corrective actions and resolution of insolvencies that was intended also to
counteract the bureaucratic tendencies toward forbearance and postponement
(principal-agent conflict). In July 1988, the Basel Committee on Banking Supervision
adopted a set of risk-based minimum-capital standards for international banks, in part
to offset the substitution of government guarantees (public capital) for private capital
in banks (Peltzman 1970). However, banks often take steps to avoid those regulations
that they find onerous and to arbitrage against (to “game”) those they find inadequate,
and such reactions give rise
to another layer of distortion costs (Jones 2000). For example, the initial Basel Accord
assigned only a 20 percent risk weight to short-term interbank loans. Banks in the
East Asian countries borrowed heavily in dollars in the early 1990s and relent at
higher rates in their domestic currency, which helped to precipitate a crisis when their
exchange rates had to be devalued. But foreign-exchange risk was not captured in the
Basel standards, and the lending bank creditors generally were protected in the
ensuing International Monetary Fund (IMF) rescues, again to the impairment of
market discipline. In 1999 and 2001, the Basel Committee proposed reforms in its
standards to meet these objections. It refined the risk categories and weights; added
capital requirements for operational risk; permitted the use of bond ratings assigned
to borrowers by recognized rating agencies to categorize risk classes; permitted more
sophisticated banks to use their own internal models to evaluate credit risk; and
expanded the sole emphasis on minimum-capital requirements (pillar one) to include
provisions for improving supervisory review (pillar two) and market discipline (pillar
three). Nevertheless, many shortcomings remain. The U.S. Shadow Financial
Regulatory Committee (2000 and 2001), among others, has made recommendations
for correcting these shortcomings, but many problems remain.
The moral-hazard and principal-agent problems that poorly priced deposit insurance
creates, or at least exacerbates, suggest that the cost-benefit balance would be
improved if insurance coverage were provided beyond small accounts at most only in
the event of a macroshock. In all other failures, claimants on the bank would not be
protected by the government de facto as well as de jure and in their own interest
would have to exert market discipline on bank management at all times. As noted, it
is more problematic to assign preventive responsibility to the bank or to its depositors
in the case of macro–policy failures, but it would be difficult ex ante for regulators to
ascertain the beginning of a macrocrisis or to draw the line as to when a number of
individual failures fall into that category. And politically it would no doubt be a
difficult distinction to sell.

If it is not feasible to limit the government safety net to macroshocks, however, it is

feasible to restructure its operation to reduce the adverse side effects. Such instructed
to establish a risk-based assessment system for deposit insurance, replacing the half-
century-old uniform flat rate and its contributions to moral hazard (Shiers 1994).
Supervisory discretion to forbear was intended to be narrowed sharply, though hardly
abolished, by specification of a structure of mandatory, presumptive, and optional

18
 corrective actions, geared to a set of five declining capital levels. In particular, when
an institution became “critically undercapitalized” (with a ratio of tangible equity to
total assets of less than 2 percent), the supervisor was to set in motion a process of
relatively speedy sale or closure (Benston and Kaufman 1994; Scott 1993). In
resolving a failed institution, the FDIC was enjoined to employ the least costly
method of meeting its insurance obligation and not to protect creditors or uninsured
depositors if doing so would increase its losses. An exception is made for cases of
systemic risk, but it is viewed skeptically; to invoke it, the FDIC must have the
concurrence in writing of two-thirds of the Federal Reserve Board and of the
secretary of th e Treasury (after consultation with the president), and then it must
recover its loss by a special assessment on the banking industry. It is unlikely that a
“too big to fail” policy, in which uninsured depositors are protected fully against loss,
will be as much relied on in the future as in the past.

Other aspects of the current U.S. deposit-insurance system also deserve comment in
relation to the handling of macroshocks. Two features reduce the impact of bank
failures on deposit holders, on the money supply, and on the economy. First, as noted
earlier, depositors are not cut off from their funds for long when their institutions are
resolved; insured deposits are paid within a business day or two, and advance
dividends on uninsured claims often are paid at approximately the same time, based
on the estimated recovery value of the failed bank’s assets (FDIC 1998; Kaufman and
Seelig 2002). Simply shutting down a failed bank for an indeterminate period and
freezing deposits, as supervisors often have done in some countries, feeds incentives
to run on all possibly affected banks at the first suggestion of trouble.
Second, the policy of prompt resolution of insolvent or nearly insolvent banks, if properly
implemented by the supervisory agencies, should result in relatively small if any
losses to depositors. If bank failure produces no or only moderate losses (except to
shareholders), those losses can be absorbed by the capital buffer at other banks, and
there should be little contagion or systemic risk. This consideration underlines the
importance of banking agencies’ having and enforcing credible and predictable
closure (resolution) rules prior to the development of massive losses, as in the 1980s.

Failure Chains

With respect to chain-reaction or direct-causation failures flowing through interconnected

institutions, there are two lines of attack. Supervisors, as just noted, can reduce
the amount of loss in the initial failure by prompt closure rules. Private banks also have
many ways, such as careful monitoring and exposure ceilings, to protect themselves
against defaults by their counterparties, and it is important that regulation not undermine
their incentives to do so (Rochet and Tirole 1996). Deposit insurance should not
cover interbank transactions; no weaker claim for customer protection can exist than
that of another institution in the same business engaging in informed and voluntary
dealings. A fortiori, there should be no safety-net “too big to fail” policy (meaning too
big to pay off in full all depositors and even other creditors at failed institutions)—a

19
policy that eliminates entirely the need for counterparties to the largest banks to take
even elementary measures to reduce their risk exposure.

In the current technological environment, the greatest volume of interbank

transactions takes place through the large-value-payments system, and it now is
viewed often as a focal point of systemic risk (Corrigan 1987). In 1999, the average
daily value of funds transfers through Fedwire was almost $1.4 trillion and
of government securities approximately $700 billion (Federal Reserve Board
2000). If the failure and resolution of a major bank caused it to be unable to
meet its payment obligations in these transactions, fear of a cascade of defaults
throughout the system might arise, producing a “gridlock.” The Fed’s response
was to guarantee payment of transfers made by a bank on Fedwire, thereby
assuming the credit risk that the transfers might not be fully collectible at the end
of the day. Until 1994, the Fed provided this guarantee of such daylight overdrafts
without charge. Therefore, of course, banks had little reason to pay close attention
to the financial condition of their interbank payments to counterparties, and the
Fed’s exposure on daylight overdrafts grew accordingly (Hancock, Wilcox, and
Humphrey 1996).

Since 1994, the Fed has tried to limit the problem by making a charge (at a relatively
low current annualized rate of 0.36 percent) for daylight overdrafts and by setting
caps on net-debit positions. Still, it funds approximately 40 percent of funds
transfers by extending daylight overdraft credit (McAndrews and Rajan 2000), which
in 1999 ran at an average magnitude of $50 billion per minute (Zhou 2000). Once
again, regulation has served to weaken banks’ incentives to protect themselves. Without
payment finality, banks would themselves limit their exposure by monitoring and rating
their counterparties, charging accordingly for credit extended, limiting the size
of their credit positions, and requiring collateral. Most important, U.S. banks would
have strong reasons to push for the full implementation of a real-time grosssettlement
system that transfers only good funds (payment versus payment and delivery
versus payment) without government credit guarantees.

By imposing policies of credit allocation toward “favored” borrowers—be they

cronies, perceived socially desirable sectors, or politically potent voter groups—
governments can impair, sometimes severely, an institution’s efforts to manage its
risks and portfolio prudently. Such pressure has affected the banking systems of most
countries to varying degrees, particularly in countries that permit state-owned banks.
To stay close to home, the United States for half a century legally restricted thrift
institutions for the most part to investing in local residential construction and ownership
and to financing long-term, fixed-rate, residential mortgage loans with shortterm
deposits. This requirement left them woefully undiversified in both a geographical
and a product sense. The consequences were no small factor in the S&L
catastrophe of the 1980s (Scott 1990).

In addition to losses to uninsured depositors at an affected bank, another chain

of transmission of adverse shocks to banks is sometimes said to be complex transactions,
particularly on derivatives markets, between a very large bank and other banks

20
and nonbank parties. The banks need to unwind these positions quickly before maturity
may generate large fire-sale losses and disorderly markets. The Prompt Corrective
Action (PCA) provisions of the FDICIA reduce, even if they do not eliminate, this
possibility by requiring bank supervisors to become progressively more familiar with
financially troubled banks as their capital ratios decline through the undercapitalized
zones. This process should provide the regulators with sufficient time to plan and prepare
for the sale of an institution before it reaches the 2 percent equity-to-capital ratio
closure rule or shortly thereafter within the permissible 90-day (extendable to 270-
day) period to minimize any disorderly ramifications of the resolution. If successful,
the regulators can achieve the dual public-policy goal of having the uninsured depositors
at risk and maintaining orderly markets without invoking the systemic risk or
“too big to fail” exemption. Indeed, if the regulators need some additional time to
unwind very large and complex banks in an orderly way, provisions exist for the
chartering and temporary operation of a bridge bank for this purpose.

Common-Shock or Reassessment Failures

The other mechanism of contagion identified earlier is the failure or near failure of
one or several institutions from losses originating elsewhere and the reassessment by
depositors, creditors, and shareholders of other institutions (common-shock contagion).
Debate over this category has concerned whether the reassessment of risk, in
light of new information revealed by the initial failures, is rational and discriminating
or panic driven and undifferentiated.
The evidence reviewed earlier indicates that depositors have done much better
than they usually are given credit for in distinguishing insolvent from solvent banks
and in shutting down the former through runs more quickly than supervisors might
have been inclined to do. It is not necessary, however, to resolve that debate definitively
in order to draw lessons from it for the banking agencies.
The obvious lesson is that banking supervisors should not impede but instead
should enhance the disclosure of information about the financial condition of banking
institutions. Bank depositors, like bank counterparties, in many instances can protect
themselves if all reason to do so is not destroyed. At the same time, supervisors should
facilitate their ability to differentiate among banks in a time of crisis or uncertainty.
One step supervisors can take to enhance bank transparency would be to permit,
rather than forbid, banks to disclose the contents of their examination reports and
supervisory ratings (Jones and King 1995). The banking agencies, viewing examination
reports as their private property, usually refuse to allow outside auditors access to
them. In 1989, Congress required such access by statute but eliminated that provision
two years later in the FDICIA. The current practice of mandatory secrecy, a skeptic
might argue, apparently is founded either on the notion that depositor confidence
must be based on ignorance or on the proposition that management is willing to
reveal negative information to examiners because they believe nothing much will
result from it, compared to the consequences of telling the world at large, or perhaps
on the reluctance of regulators to face a market test. None of these positions is reassuring.
Another step would be to encourage banks to disclose market values of all assets
and liabilities in financial statements, at least in footnotes. Not all items can be so valued
with precision, but many more can be estimated reasonably accurately and already

21
are in banks’ internal risk-management models and calculations. If proposals for larger
banks to issue uninsured subordinated debt (U.S. Shadow Financial Regulatory
Committee 2000) bear fruit, the market will demand more disclosure of such
information.
The FDICIA enjoined banking agencies to develop within a year a method “to provide
supplemental disclosure of the estimated fair market value of assets and liabilities,
to the extent feasible and practicable, in any balance sheet, financial statement, report
of condition, or other report”. Unfortunately, nothing came of this congressional mandate.

RISK MANAGEMENT AND CONTINGENCY ESTIMATING

Contingency estimating is one step the risk management process. As defined by AACE
International, the risk management process includes identifying and analyzing risk
factors or drivers, mitigating the risk drivers where appropriate, estimating
their impact on plans (e.g., including setting contingency after mitigation) and then
monitoring and controlling risk during execution [4]. A key concept in risk
anagement is that the contingency estimate must reflect the quantified impacts of risk
“drivers” or causes; the process seeks to mitigate and manage these drivers. In other
words, contingency estimating is not an end in itself; it is part of a driver-focused
process.
In line-by-line Monte Carlo, users do not model how risk drivers affect cost outcomes.
Sometimes the project team will go through the effort to identify and discuss risk
drivers in the risk analysis meeting, but when it comes time to quantify the risks and
estimate contingency, they revert to applying high-low ranges to line-items with only
the vaguest idea of how any particular risk driver affects the cost of a given line item.
In best practice, the contingency estimating method should explicitly model and
document how the risk drivers affect the cost outcomes. Such as model would
support risk management and contingency drawdown during project execution (i.e.,
as teams monitor and assess risk drivers during project execution, they can determine
if the risk drivers have or have not happened, and the associated contingency can be
rationally managed).

The definition of contingency and how to estimate it are among the most controversial
topics in cost engineering. While there is consensus among cost engineers on what
contingency is, there is much less consensus on how to estimate it. This lack of
consensus and the unfortunate political nature of contingency issues partly explains

22
 why AACE International has never established a recommended practice for how to
estimate contingency.

In general, Industry can agree that there are four general classes of methods used to
estimate contingency. These include the following:

 • Expert judgment.

 • Predetermined guidelines (with varying degrees of judgment and empiricism used).

 • Monte Carlo or other simulation analysis (primarily risk analysis judgment

incorporated in a simulation). And,

 • Parametric Modeling (empirically-based algorithm, usually derived through

regression analysis, with varying degrees of judgment used).

I know of only one published study of the efficacy of these methods. In 2004,
Independent Project Analysis (IPA) presented a paper that for the first time
quantitatively explored the historical performance of the various techniques [2]. The
IPA authors found that, despite decades of discussion and development, “…
contingency estimates are, on average, getting further from the actual contingency
required.” They further state that, “This result is especially surprising considering that
the percentage of projects using more sophisticated approaches to contingency setting
has been increasing.” In particular when they looked at projects for which the scope
was poorly defined, they found that the more sophisticated techniques were “a
disaster”.

The sophisticated techniques they referred to were predominately Monte Carlo analysis of
line-item ranges. Given how popular Monte Carlo has become, these are sobering
findings that cost engineers must not ignore.

The IPA paper offered a partial remedy; namely that empirical, regression-based models
“…can be a viable alternative or an excellent supplement to the traditionally used
methods for contingency setting.” This is particularly true when project scope is

poorly defined. In summary, the lesson learned from the IPA study is that Monte Carlo, as
practiced, is failing and we need to find better methods that incorporate the best of
expert judgment judgment, empirically-based knowledge, and risk analysis methods
such as Monte-Carlo.

This paper outlines a practical approach for estimating contingency that addresses the
findings of the IPA research, and, in my opinion, better represent best-practice.
However, before outlining the improved methods, more explanation is in order as to

23
why line-by-line Monte-Carlo often does not work and what the attributes of a best
practice should be.

MONTE CARLO (AS COMMONLY MISPRACTICED)

The most common method of Monte Carlo based contingency estimating used by industry
is “line-by-line” estimating of ranges with Monte Carlo simulation applied. In this
approach, as commonly applied, the estimate line-items (e.g., install steel
structure, mechanical engineering, etc.), or estimate subtotals by work breakdown or other
estimate categories are entered in an Excel spreadsheet which serves as the starting
basis of a Monte Carlo model. The more detailed the estimate, the more
lines that are usually modeled. Using @Risk® or a similar spreadsheet add-on program,
the analyst/estimator then replaces each fixed line-item or subtotal cost entry with a
statistical distribution of cost outcomes for the line item. These line
item distributions are the simulation model inputs. For simplicity, the distribution used is
almost always “triangular” with the line-item point estimate being the peak value, and
the high and low “range” points of the triangle being assigned by the analyst or the
project team during a “risk analysis” meeting. The highlow range is usually skewed
to the high side (e.g., +50 percent/- 30 percent). The analyst then runs the Monte
Carlo model simulation to obtain a distribution of bottom line cost outcomes.
Users like the simplicity of the line-by-line range estimating method. Management likes
the graphical outputs.
Unfortunately, the method as generally practiced is highly flawed. First, the outcomes are
unreliable because few practitioners define the “dependencies” or correlation between
the model inputs (i.e., between the estimate line-items). Valid
Monte Carlo modeling requires the analyst to quantify the degree to which each line item
is related to the others. @Risk incorporates correlation matrices to facilitate this task.
As an example of cost dependency, most estimators would agree that construction
management costs are somewhat dependent on field labor costs; if field labor costs
come in high, it is likely that construction management will also come in high.
With independent inputs, each Monte Carlo simulation iteration will pick high values for
some items and low values for others. The highs and lows tend to cancel each other
out. The result is too low of a contingency (i.e., too tight of an outcome
distribution). Furthermore, analysts can easily bias the simulation outcome without
changing any of the risk analysis ranges; all they need to do is change the number of
line items represented by distributions in the model (e.g., look only at subtotals).
These quirks, intentional or otherwise, mean that results are not replicable between
analysts.
If Monte Carlo is used (in any kind of model) a best practice is to define dependencies
between model variables. However, a possibly more serious shortcoming of the line-
by-line Monte Carlo method is that it is inherently inconsistent with basic risk
management principles.

THE EFFECTS OF SYSTEMIC RISK DRIVERS CAN’T BE CONSIDERED

LINE-BY-LINE

24
The AACE International definition of Contingency is “an amount added to an estimate to
allow for items, conditions, or events for which the state, occurrence, and/or effect is
uncertain and that experience shows will likely result, in aggregate, in
additional cost.”
The definition uses the words “in aggregate” for a reason. The reason is that systemic
(i.e., non-project or cost item specific) risk drivers such as the level of project scope
definition affect individual, disaggregated estimate line-items in ways that are hard to
see and predict. For example, no team member in a risk
analysis can really judge how “poor scope definition” will affect a line-item such as civil
engineering, steel structure, and so on.
The relationship of systemic risk drivers to cost impacts at a disaggregated level is highly
obscure—only empirical, statistical research shows a clear relationship to cost
growth, and then only to bottom-line or highly aggregated costs.
Project teams that evaluate risks line-by-line are also tempted to then assign contingency
to each line, subtotal or WBS element and manage it that way. One research study
indicated that this method (and the temptation to spend contingency once so
assigned) contributes to project failure.
In best practice then, a contingency estimation method should address systemic risk
drivers using empirical knowledge (actual drivers and project cost history) to produce
stochastic models that link known risk drivers (e.g., level of scope definition,
level of technology, etc.) to bottom-line project cost growth.

CONFUSING COST DRIVERS WITH RISK DRIVERS

Risks are things that drive uncertainty of future outcomes. Risks should not be confused
with things that are simply higher in cost. For example, some people will say that
revamp work in a process plant is “risky” because it costs more (or takes more hours)
than new work. However, revamp work is an attribute of a project scope that only
increases the risk significantly if the scope development and project planning
practices that define and mitigate the potential cost impacts of revamp work are not
done well. If the process plant as-built and physical condition has been well
examined, the range of possible cost outcomes (or risk) for revamp work will not be
significantly wider than new work in percentage terms. In this case, the level of scope
definition and planning is the risk driver or cause, not the fact that the work is revamp
(which may be a cost driver).

This relates to our discussion of line-by-line Monte Carlo because, lacking a focus on risk
drivers, teams using this method tend to focus on why line item costs are high. The
exercise becomes focused on cost reduction or value improvement rather than risk
mitigation. While total cost management recognizes that value and risk management
are closely related concepts and should be practiced in an integrated way, users must
be careful not to confuse them. Once again, the confusion comes because systemic
risk drivers cannot be effectively discussed or dealt with at a line item level.

25
In best practice, a combined risk analysis/contingency estimating method should start
with identifying the risk drivers and events. The cost impacts of the risk drivers and
events are then considered specifically for each driver. For systemic risk drivers,
stochastic estimating methods are best. However, for project or item specific risks, more
deterministic cost estimates of the effects of risk drivers are generally appropriate.

PROBABILITIES, RANGES AND CONTINGENCY ESTIMATING

There is industry consensus that probabilistic contingency estimating, that addresses the
predictive nature of cost estimating, is a best practice. A cost estimate is not a single
value, but a distribution of probable outcomes. As shown in Figure 1, using
a probabilistic method, contingency is simply an amount of money that must be added to
the point estimate (i.e., best estimate of all known items) to obtain a cost value that
provides management with an acceptable level of confidence (e.g., 50
percent) that the final cost will be less.
Distributions and ranges are one area where Monte Carlo methods always shine.
However, there is often a misunderstanding that only Monte Carlo can produce
probabilistic outcomes.
Parametric modeling methods can provide probabilistic information as well.

DRIVER-BASED METHODS: A BETTER APPROACH

In summary, line-by-line Monte Carlo range estimating for contingency is not working. In
part, this is because the method is inconsistent with best risk management practice.
The preceding assessment of line-by-line Monte Carlo’s shortcomings highlighted
that best estimating practice for contingency should
include these features:
• Start with identifying and understanding the risk drivers.
• Recognize the differences between systemic and project specific risk drivers.
• Address systemic risk drivers using empirically-based stochastic models.
• Address project-specific risk drivers using methods that explicitly link risk drivers and
cost outcomes.
• If the method uses Monte Carlo, address dependencies.

The good news is that contingency estimating methods that apply best practices are not
overly complex and the technology is well-documented. The author, in conjunction
with the Center for Cost Engineering (C4CE; an alliance of Conquest
Consulting Group and Validation Estimating LLC) have developed tools that successfully
apply these best practices. The remainder of this paper summarizes industry
information about empirically-based stochastic models, discusses project-specific
“driver-based” cost models using Monte Carlo, and reviews C4CE’s integrated
application of these practices.

26
EMPIRICAL, DRIVER-BASED STOCHASTIC CONTINGENCY MODELS IN
INDUSTRY

IPA’s 2004 research suggested empirical, regression-based contingency estimating models

as one approach for improved contingency estimating. This approach is conceptually
simple; just collect quantitative historical data about project cost
growth, practices and attributes. Then, using regression analysis, look for correlations
between the cost growth and the practices and attributes (i.e., risk drivers), keeping in
mind that you are looking for causal relationships. Unfortunately, most companies do
not have the historical data available for analysis. However,
there are publicly available industry sources that provide the basic relationships. The
primary sources include the work of the late John Hackney, the Rand Institute, and
the Construction Industry Institute (CII).
In 2002, IPA published further empirical industry research that showed that project control
practices were also a systemic risk driver [5]. Poor control practices can negate the
benefits of good project scope definition by allowing costs to grow unfettered during
execution (i.e., good project definition practices before authorization do not guarantee
well disciplined practices after).
This industry research is reflected in AACE International’s Recommended Practice for
cost estimate classification.
That document outlines the level of scope definition that is recommended for each class
of estimate (e.g., Classes 5 through 1). It also provides typical contingency and
accuracy range “bands”

Figure 2—Expected Value In a Standard Risk Model

27
(i.e., a range of ranges) for process industry projects. These range bands represent the
consensus of industry experts and are generally consistent with the outcomes of the
studies discussed here.
Lacking in-house data, a company can use the information in these studies and standards
to create a contingency estimating model based on systemic drivers. While not the
most elegant approach, the tool can be developed through trial and error.
First, substitute best and worst case ratings for each driver in each published model and
assess the sensitivity of the outcomes to the drivers. After deciding how you are going
to rate the risk drivers for your company projects (e.g., you can use the AACE
International estimate classification attributes, PDRI, Lickert scale ratings such as used by
CII, etc.), create a first-pass trial model of factors and parameters along the lines of
those published.
You may also incorporate some obvious cost growth inhibitors such as how much of the
estimate is fixed price or major equipment. Then, iteratively adjust your model until it
reasonably replicates the results of the published models and standards. The last and
most important step is to use your company’s actual risk driver and cost outcome data
to validate, calibrate and improve the model over time.

A PROJECT-SPECIFIC, DRIVER-BASED CONTINGENCY ESTIMATING

MODEL
While there are a number contingency modeling approaches possible for non-systemic,
project-specific risks (i.e., event-driven) the method that is most accessible to the
average cost engineer is event or probability tree analysis (ETA). ETA uses the
concept of expected value (EV) to quantify the likely cost outcome
of a risk event. The event tree/expected value approach is used in what some call the
“standard risk model” [6,11]. It is also used in decision analysis [10]. Figure 2
provides a simple example how the standard risk model, using the concept of EV,
can be used to estimate the expected impact on a single cost account. Project contingency
is then the sum of the expected impacts from all significant risk drivers.
Terms such as “cause-risk-effect” have been used instead of “driver-event-impact,” but
the concept is the same. A key advantage of this method is that it nambiguously ties
the risk drivers to the cost impact and therefore allows for effective risk management.
A drawback is that the method can become complex if the analyst does not screen the
risk drivers/events and focus only on those that have significant probability and
impact.
The ETA/EV approach provides point-estimates of the most likely cost impacts of each
risk driver. Without further analysis, the sum of the expected cost impacts for each
risk event can be used as the contingency. However, the method supports
probabilistic outcomes through Monte Carlo simulation. In that case, distributions are
used to express the risk event probabilities and cost impacts. To obtain range
information (i.e., cost outcome distributions), the user can enter the risk event model
in a spreadsheet and apply Monte Carlo simulation to it (making sure to address
dependencies). I call this approach driver-based Monte-Carlo (DBM) to differentiate
it from traditional line item approaches.

28
PUTTING THE METHODS INTO PRACTICE AN INTEGRATED APPROACH

Using the approaches discussed above, C4CE has developed a basic parametric
contingency estimating model for systemic risks, and an expected value template for
modeling project specific risk drivers using Monte Carlo. For early estimates (i.e.,
AACE International Class 5 or 4), the parametric model can be used alone. For
authorization and control estimates (i.e., AACE International Class 3), the tools are
integrated by incorporating the parametric model output as the first “risk driver” (i.e.,
systemic risks) in the expected value model. C4CE refers to the combined approach
as DBM. As indicated in figure 3, the DBM output is a single probabilistic cost
distribution considering all risk drivers. Contingency is then determined based on
Stock Market Investment: Understanding Systematic and Unsystematic Risk

Many people think that diversification is the way to make money in the stock
market investment. They believe that diversification is the way to diversify away all
the risks associated with stock market investment.

The Risk Pyramid

You might be familiar with the risk-reward concept, which states that the higher the risk
of a particular investment, the higher the possible return. But, many investors do not
understand how to determine the level of risk their individual portfolios should bear. This
article provides a general framework that any investor can use to assess his or her
personal level of risk and how this level relates to different investments.

Risk-Reward Concept
This is a general concept underlying anything by which a return can be expected. Anytime
you invest money into something there is a risk, whether large or small, that you might
not get your money back. In turn, you expect a return, which compensates you for bearing
this risk. In theory the higher the risk, the more you should receive for holding the
investment, and the lower the risk, the less you should receive.

For investment securities, we can create a chart with the different types of securities and
their associated risk/reward profile.

29
Although this chart is by no means scientific, it provides a guideline that investors can use
when picking different investments. Located on the upper portion of this chart are
investments that offer investors a higher potential for above-average returns, but this
potential comes with a higher risk of below-average returns. On the lower portion are
much safer investments, but these investments have a lower potential for high returns.

Determining Your Risk Preference

With so many different types of investments to choose from, how does an investor
determine how much risk he or she can handle? Every individual is different, and it's hard
to create a steadfast model applicable to everyone, but here are two important things you
should consider when deciding how much risk to take:

• Time Horizon
Before you make any investment, you should always determine the
amount of time you have to keep your money invested. If you have
$20,000 to invest today but need it in one year for a down payment on a
new house, investing the money in higher-risk stocks is not the best
strategy. The riskier an investment is, the greater its volatility or price
fluctuations, so if your time horizon is relatively short, you may be
forced to sell your securities at a significant a loss.

With a longer time horizon, investors have more time to recoup any
possible losses and are therefore theoretically be more tolerant of higher
risks. For example, if that $20,000 is meant for a lakeside cottage that
you are planning to buy in ten years, you can invest the money into
higher-risk stocks because there is be more time available to recover any
losses and less likelihood of being forced to sell out of the position too
early.

• Bankroll
Determining the amount of money you can stand to lose is another
important factor of figuring out your risk tolerance. This might not be the
most optimistic method of investing; however, it is the most realistic. By
investing only money that you can afford to lose or afford to have tied up

30
 for some period of time, you won't be pressured to sell off any
investments because of panic or liquidity issues.

The more money you have, the more risk you are able to take and vice
versa. Compare, for instance, a person who has a net worth of $50,000 to
another person who has a net worth of $5,000,000. If both invest $25,000
of their net worth into securities, the person with the lower net worth will
be more affected by a decline than the person with the higher net worth.
Furthermore, if the investors face a liquidity issue and require cash
immediately, the first investor will have to sell off the investment while
the second investor can use his or her other funds.

Investment Risk Pyramid

After deciding on how much risk is acceptable in your portfolio by acknowledging your
time horizon and bankroll, you can use the risk pyramid approach for balancing your
assets.

This pyramid can be thought of as an asset allocation tool that investors can use to
diversify their portfolio investments according to the risk profile of each security. The
pyramid, representing the investor's portfolio, has three distinct tiers:

• Base of the Pyramid– The foundation of the pyramid represents the

strongest portion, which supports everything above it. This area should
be comprised of investments that are low in risk and have foreseeable
returns. It is the largest area and composes the bulk of your assets.
• Middle Portion– This area should be made up of medium-risk
investments that offer a stable return while still allowing for capital
appreciation. Although more risky than the assets creating the base, these
investments should still be relatively safe.

31
 • Summit– Reserved specifically for high-risk investments, this is the
smallest area of the pyramid (portfolio) and should be made up of money
you can lose without any serious repercussions. Furthermore, money in
the summit should be fairly disposable so that you don't have to sell
prematurely in instances where there are capital losses.

Personalizing the Pyramid

Not all investors are created equally. While others prefer less risk, some investors
prefer even more risk than others who have a larger net worth. This diversity leads to
the beauty of the investment pyramid. Those who want more risk in their portfolios
can increase the size of the summit by decreasing the other two sections, and those
wanting less risk can increase the size of the base. The pyramid representing your
portfolio should be customized to your risk preference.

It is important for investors to understand the idea of risk and how it applies to them.
Making informed investment decisions entails not only researching individual
securities but also understanding your own finances and risk profile. To get an
estimate of the securities suitable for certain levels of risk tolerance and to maximize
returns, investors should have an idea of how much time and money they have to
invest and the returns they are looking for.

Systematic Risk and Unsystematic Risk (Finance & Investments)

Systematic risk is due to risk factors that affect the entire market such as investment
policy changes, foreign investment policy, change in taxation clauses, shift in socio-
economic parameters, global security threats and measures etc.

Unsystematic risk is due to factors specific to an industry or a company like labor unions,
product category, research and development, pricing, marketing strategy etc.

Systematic risk is beyond the control of investors and cannot be mitigated to a large
extent. In contrast to this, the unsystematic risk can be mitigated through portfolio
diversification. It is a risk that can be avoided and the market does not compensate for
taking such risks.

However the systematic risks are unavoidable and the market does compensate for taking
exposure to such risks.

This logic forms the base for the capital asset pricing model. The greater is the systematic
risk, the greater is the return expected out of the asset. The relationship between the
expected returns and systematic risk is what the CAPM (Capital Asset Pricing Model)
explains.

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Capital Asset Pricing Model

In finance, the capital asset pricing model (CAPM) is used to determine a theoretically
appropriate required rate of return of an asset, if that asset is to be added to an
already well-diversified portfolio, given that asset's non-diversifiable risk. The
model takes into account the asset's sensitivity to non-diversifiable risk (also known
as systematic risk or market risk), often represented by the quantity beta (β) in the
financial industry, as well as the expected return of the market and the expected
return of a theoretical risk-free asset.
The model was introduced by Jack Treynor (1961, 1962)[1], William Sharpe (1964),
John Lintner (1965a,b) and Jan Mossin (1966) independently, building on the
earlier work of Harry Markowitz on diversification and modern portfolio theory.
Sharpe, Markowitz and Merton Miller jointly received the Nobel Memorial Prize
in Economics for this contribution to the field of financial economics.

33
The Security Market Line, seen here in a graph, describes a relation between the beta and
the asset's expected rate of return.
The formula

The CAPM is a model for pricing an individual security or a portfolio. For individual
securities, we made use of the security market line (SML) and its relation to expected
return and systematic risk (beta) to show how the market must price individual securities
in relation to their security risk class. The SML enables us to calculate the reward-to-risk
ratio for any security in relation to that of the overall market. Therefore, when the
expected rate of return for any security is deflated by its beta coefficient, the reward-to-
risk ratio for any individual security in the market is equal to the market reward-to-risk
ratio, thus:

The market reward-to-risk ratio is effectively the market risk premium and by rearranging
the above equation and solving for E(Ri), we obtain the Capital Asset Pricing Model
(CAPM).

where:

• is the expected return on the capital asset

• is the risk-free rate of interest such as interest arising from government bonds
• (the beta coefficient) is the sensitivity of the asset returns to market returns, or

also ,
• is the expected return of the market
• is sometimes known as the market premium or risk premium (the
difference between the expected market rate of return and the risk-free rate of
return).

34
Restated, in terms of risk premium, we find that:

which states that the individual risk premium equals the market premium times β.

Note 1: the expected market rate of return is usually estimated by measuring the
Geometric Average of the historical returns on a market portfolio (i.e. S&P 500).

Note 2: the risk free rate of return used for determining the risk premium is usually the
arithmetic average of historical risk free rates of return and not the current risk free rate of
return.

For the full derivation see Modern portfolio theory.

Risk and diversification

The risk of a portfolio comprises systematic risk, also known as undiversifiable risk, and
unsystematic risk which is also known as idiosyncratic risk or diversifiable risk.
Systematic risk refers to the risk common to all securities - i.e. market risk. Unsystematic
risk is the risk associated with individual assets. Unsystematic risk can be diversified
away to smaller levels by including a greater number of assets in the portfolio (specific
risks "average out"). The same is not possible for systematic risk within one market.
Depending on the market, a portfolio of approximately 30-40 securities in developed
markets such as UK or US will render the portfolio sufficiently diversified to limit
exposure to systematic risk only. In developing markets a larger number is required, due
to the higher asset volatilities.

A rational investor should not take on any diversifiable risk, as only non-diversifiable
risks are rewarded within the scope of this model. Therefore, the required return on an
asset, that is, the return that compensates for risk taken, must be linked to its riskiness in a
portfolio context - i.e. its contribution to overall portfolio riskiness - as opposed to its
"stand alone riskiness." In the CAPM context, portfolio risk is represented by higher
variance i.e. less predictability. In other words the beta of the portfolio is the defining
factor in rewarding the systematic exposure taken by an investor.

The efficient frontier

Main article: Efficient frontier

35
The (Markowitz) efficient frontier. CAL stands for the capital allocation line.

The CAPM assumes that the risk-return profile of a portfolio can be optimized - an
optimal portfolio displays the lowest possible level of risk for its level of return.
Additionally, since each additional asset introduced into a portfolio further diversifies the
portfolio, the optimal portfolio must comprise every asset, (assuming no trading costs)
with each asset value-weighted to achieve the above (assuming that any asset is infinitely
divisible). All such optimal portfolios, i.e., one for each level of return, comprise the
efficient frontier.

Because the unsystematic risk is diversifiable, the total risk of a portfolio can be viewed
as beta.

The market portfolio

An investor might choose to invest a proportion of his or her wealth in a portfolio of risky
assets with the remainder in cash - earning interest at the risk free rate (or indeed may
borrow money to fund his or her purchase of risky assets in which case there is a negative
cash weighting). Here, the ratio of risky assets to risk free asset does not determine overall
return - this relationship is clearly linear. It is thus possible to achieve a particular return
in one of two ways:

1. By investing all of one's wealth in a risky portfolio,

2. or by investing a proportion in a risky portfolio and the remainder in cash (either
borrowed or invested).

For a given level of return, however, only one of these portfolios will be optimal (in the
sense of lowest risk). Since the risk free asset is, by definition, uncorrelated with any
other asset, option 2 will generally have the lower variance and hence be the more
efficient of the two.

This relationship also holds for portfolios along the efficient frontier: a higher return
portfolio plus cash is more efficient than a lower return portfolio alone for that lower level
of return. For a given risk free rate, there is only one optimal portfolio which can be

36
combined with cash to achieve the lowest level of risk for any possible return. This is the
market portfolio.

Assumptions of CAPM

All Investors:

1. Aim to maximize economic utility.

2. Are rational and risk-averse.
3. Are price takers, i.e., they cannot influence prices.
4. Can lend and borrow unlimited under the risk free rate of interest.
5. Trade without transaction or taxation costs.
6. Deal with securities that are all highly divisible into small parcels.
7. Assume all information is at the same time available to all investors.

Shortcomings of CAPM

• The model assumes that asset returns are (jointly) normally distributed random
variables. It is however frequently observed that returns in equity and other
markets are not normally distributed. As a result, large swings (3 to 6 standard
deviations from the mean) occur in the market more frequently than the normal
distribution assumption would expect.
• The model assumes that the variance of returns is an adequate measurement of
risk. This might be justified under the assumption of normally distributed returns,
but for general return distributions other risk measures (like coherent risk
measures) will likely reflect the investors' preferences more adequately.
• The model assumes that all investors have access to the same information and
agree about the risk and expected return of all assets (homogeneous expectations
assumption).
• The model assumes that the probability beliefs of investors match the true
distribution of returns. A different possibility is that investors' expectations are
biased, causing market prices to be informationally inefficient. This possibility is
studied in the field of behavioral finance, which uses psychological assumptions to
provide alternatives to the CAPM such as the overconfidence-based asset pricing
model of Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam (2001)[2].
• The model does not appear to adequately explain the variation in stock returns.
Empirical studies show that low beta stocks may offer higher returns than the
model would predict. Some data to this effect was presented as early as a 1969
conference in Buffalo, New York in a paper by Fischer Black, Michael Jensen,
and Myron Scholes. Either that fact is itself rational (which saves the efficient-
market hypothesis but makes CAPM wrong), or it is irrational (which saves
CAPM, but makes the EMH wrong – indeed, this possibility makes volatility
arbitrage a strategy for reliably beating the market).
• The model assumes that given a certain expected return investors will prefer lower
risk (lower variance) to higher risk and conversely given a certain level of risk will
prefer higher returns to lower ones. It does not allow for investors who will accept

37
 lower returns for higher risk. Casino gamblers clearly pay for risk, and it is
possible that some stock traders will pay for risk as well.
• The model assumes that there are no taxes or transaction costs, although this
assumption may be relaxed with more complicated versions of the model.
• The market portfolio consists of all assets in all markets, where each asset is
weighted by its market capitalization. This assumes no preference between
markets and assets for individual investors, and that investors choose assets solely
as a function of their risk-return profile. It also assumes that all assets are infinitely
divisible as to the amount which may be held or transacted.
• The market portfolio should in theory include all types of assets that are held by
anyone as an investment (including works of art, real estate, human capital...) In
practice, such a market portfolio is unobservable and people usually substitute a
stock index as a proxy for the true market portfolio. Unfortunately, it has been
shown that this substitution is not innocuous and can lead to false inferences as to
the validity of the CAPM, and it has been said that due to the inobservability of
the true market portfolio, the CAPM might not be empirically testable. This was
presented in greater depth in a paper by Richard Roll in 1977, and is generally
referred to as Roll's critique.
• The model assumes just two dates, so that there is no opportunity to consume and
rebalance portfolios repeatedly over time. The basic insights of the model are
extended and generalized in the intertemporal CAPM (ICAPM) of Robert Merton,
and the consumption CAPM (CCAPM) of Douglas Breeden and Mark Rubinstein.

SYSTEMATIC AND UNSYSTEMATIC RISK OF RATES OF RETURN

ASSOCIATED WITH SELECTED FOREST PRODUCTS COMPANIES

The objective of most investors in stocks or other assets is to maximize the expected
returns in a given risk class; in other words, to minimize risk for a given level of
expected returns. Although "risk" may connote the chance of injury or loss, the
term is not defined so narrowly in this article. Rather, it is used to reflect
volatility in stock or other assets' rates of return and should not be confused
with risk and uncertainty in the production process.

Risk, as approached herein, equals the variance of historical rates of return about
the average rate of return.

Total risk of an investor's investment port-folio can be reduced through investment

diversification, that is, by the purchase of different kinds of assets (stocks,
bonds, securities, real estate, etc.) and by the purchase of stocks or bonds from

38
 more than one company or industry. However, risk cannot be reduced in this
way beyond a certain limit because changes in over-all market conditions affect
price variations in all stocks and other assets and this variability cannot be
eliminated completely by diversification.

As a result, it is desirable to separate total risk, or variation in rates of return, into

two components-one reflecting that portion of an asset's price movements
caused by changes in the market as a whole and a second reflecting that portion
of an asset's price movements caused by factors or variables unique to the
company or industry itself. The former is called "systematic risk" (and is
nondiversifiable) and the latter "unsystematic risk".

Unsystematic risk, related to such factors as labor strikes, inventions, research and
developments, and the like is diversifiable.

A stock is said to be more desirable for portfolio diversification purposes if only a

small proportion of its volatility can be attributed to the impact of the market
[4], unless, of course, an investor wishes to invest in assets whose rates of return
follow those of the market as a whole. A measurement of systematic and
unsystematic risk is needed from which the percentage of total risk accounted
for by each can be calculated.

The purpose of this article is to measure total, systematic, and unsystematic risk of
the rates of return of a select group of forest products firms.

In measuring risk it is desirable to determine that portion associated with the

market and that portion associated with the company itself.

Are rates of return of forest products companies relatively volatile? Or do they

generally follow market changes and trends? Unsystematic risk will measure the
former and unsystematic risk the latter.

EXAMPLE

Total, systematic, and unsystematic risk associated with the rates of return of five
forest products companies are calculated to illustrate how the model is used. The
firms analyzed are Crown Zellerbach, Potlatch, International Paper, Westvaco,

39
and Weyerhaeuser. Each firm is large, having landholdings and processing
plants in more than one region of the country. The analysis allows total risk and
its components for each of the companies to be compared. In addition, the
results of such an analysis aid in determining whether large forest products
companies are more or less susceptible than companies in other industries to
factors that affect the market as a whole, or to factors which are in herent or
unique to the particular companies or industries themselves.

40
Sources of Systematic vs. Unsys. Risk

What are the Sources of Risk?

Announcements & Exp. Returns

Actual returns (R) will be:

`R + U (expected + unexpected)
Investors form “expectations” about future
Expected information is already discounted by the market
i.e., the value of the information is already incorporated into the stock prices

Attempts to exploit Public information (make large returns) will not be successful.

Surprises

• Unexpected Returns: caused by surprises

• Surprises can be GOOD or BAD!
• Total return (R) = E(R) + U
• Announcements are news only to the extent they contain “surprise” element
• “No burglary in BG on Sept. 28” --no news
• “No burglary in New York on Sept. 28”-- major news!

Systematic vs. Unsys. Surprises

• Systematic risk:
• surprises that affect “large” no. of assets
• Usually in the same “direction”
• I/Rs, Unemployment, Elections, GDP,……
• Unsystematic risk:
• surprises that affect “small” no. of assets
• Some “firm-specific” news turn into “economy-wide” events!!!`
• R = `R + U = `R + m + e

41
Risk: Systematic &Unsystematic

We can break down the risk, U, of holding a stock into two components: systematic risk
and unsystematic risk:

σ R = R +U
becomes
Total risk; U
R = R+m+ε
where
ε m is the systematic risk
ε is the unsystematic risk
Nonsystematic Risk;
ε
Systematic Risk; m

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Risk and Diversification

Risk and Diversification: What Is Risk?

Whether it is investing, driving, or just walking down the street, everyone exposes
themselves to risk. Your personality and lifestyle play a big role in how much risk you are
comfortably able to take on. If you invest in stocks and have trouble sleeping at night, you
are probably taking on too much risk. (For more insight, see A Guide To Portfolio
Construction.)

Risk is defined as the chance that an investment's actual return will be different than
expected. This includes the possibility of losing some or all of the original investment.

Those of us who work hard for every penny we earn have a harder time parting with
money. Therefore, people with less disposable income tend to be, by necessity, more risk
averse. On the other end of the spectrum, day traders feel if they aren't making dozens of
trades a day there is a problem. These people are risk lovers.

When investing in stocks, bonds, or any investment instrument, there is a lot more risk
than you'd think. In the next section, we'll take a look at the different kind of risk that
often threaten investors' returns.

Risk and Diversification: Different Types of Risk

Let's take a look at the two basic types of risk:

• Systematic Risk - Systematic risk influences a large number of

assets. A significant political event, for example, could affect several of the assets
in your portfolio. It is virtually impossible to protect yourself against this type of
risk.

• Unsystematic Risk - Unsystematic risk is sometimes referred to as "specific

risk". This kind of risk affects a very small number of assets. An example is news
that affects a specific stock such as a sudden strike by employees. Diversification
is the only way to protect yourself from unsystematic risk. (We will discuss
diversification later in this tutorial).

Now that we've determined the fundamental types of risk, let's look at more

43
 specific types of risk, particularly when we talk about stocks and bonds.

• Credit or Default Risk - Credit risk is the risk that a company or individual will
be unable to pay the contractual interest or principal on its debt obligations. This
type of risk is of particular concern to investors who hold bonds in their portfolios.
Government bonds, especially those issued by the federal government, have the
least amount of default risk and the lowest returns, while corporate bonds tend to
have the highest amount of default risk but also higher interest rates. Bonds with
a lower chance of default are considered to be investment grade, while bonds with
higher chances are considered to be junk bonds. Bond rating services, such as
Moody's, allows investors to determine which bonds are investment-grade, and
which bonds are junk. (To read more, see Junk Bonds: Everything You Need To
Know, What Is A Corporate Credit Rating and Corporate Bonds: An Introduction
To Credit Risk.)

• Country Risk - Country risk refers to the risk that a country won't be able to
honor its financial commitments. When a country defaults on its obligations, this
can harm the performance of all other financial instruments in that country as well
as other countries it has relations with. Country risk applies to stocks, bonds,
mutual funds, options and futures that are issued within a particular country. This
type of risk is most often seen in emerging markets or countries that have a severe
deficit. (For related reading, see What Is An Emerging Market Economy?)

• Foreign-Exchange Risk - When investing in foreign countries you must consider

the fact that currency exchange rates can change the price of the asset as
well. Foreign-exchange risk applies to all financial instruments that are in a
currency other than your domestic currency. As an example, if you are a resident
of America and invest in some Canadian stock in Canadian dollars, even if the
share value appreciates, you may lose money if the Canadian dollar depreciates in
relation to the American dollar.

Interest Rate Risk - Interest rate risk is the risk that an investment's value will
change as a result of a change in interest rates. This risk affects the value of bonds
more directly than stocks. (To learn more, read How Interest Rates Affect The
Stock Market.)

• Political Risk - Political risk represents the financial risk that a country's
government will suddenly change its policies. This is a major reason why
developing countries lack foreign investment.

• Market Risk - This is the most familiar of all risks. Also referred to as volatility,
market risk is the the day-to-day fluctuations in a stock's price. Market risk applies
mainly to stocks and options. As a whole, stocks tend to perform well during a
bull market and poorly during a bear market - volatility is not so much a cause but
an effect of certain market forces. Volatility is a measure of risk because it refers
to the behavior, or "temperament", of your investment rather than the reason for

44
 this behavior. Because market movement is the reason why people can make
money from stocks, volatility is essential for returns, and the more unstable the
investment the more chance there is that it will experience a dramatic change in
either direction.

As you can see, there are several types of risk that a smart investor should consider
and pay careful attention to.

Risk and Diversification: The Risk-Reward Tradeoff

The risk-return tradeoff could easily be called the iron stomach test. Deciding what
amount of risk you can take on is one of the most important investment decision you will
make.

The risk-return tradeoff is the balance an investor must decide on between the desire for
the lowest possible risk for the highest possible returns. Remember to keep in mind that
low levels of uncertainty (low risk) are associated with low potential returns and high
levels of uncertainty (high risk) are associated with high potential returns.

The risk-free rate of return is usually signified by the quoted yield of "U.S. Government
Securities" because the government very rarely defaults on loans. Let's suppose that the
risk-free rate is currently 6%. Therefore, for virtually no risk, an investor can earn 6% per
year on his or her money. But who wants 6% when index funds are averaging 12-14.5%
per year? Remember that index funds don't return 14.5% every year, instead they return
-5% one year and 25% the next and so on. In other words, in order to receive this higher
return, investors much also take on considerably more risk.

The following chart shows an example of the risk/return tradeoff for investing. A higher
standard deviation means a higher risk:

45
 In the next section, we'll show you what you can do to reduce the risk in your
portfolio with an introduction to the diversification.

Risk and Diversification: Diversifying Your Portfolio

With the stock markets bouncing up and down 5% every week, individual investors
clearly need a safety net. Diversification can work this way and can prevent your entire
portfolio from losing value.

Diversifying your portfolio may not be the sexiest of investment topics. Still, most
investment professionals agree that while it does not guarantee against a loss,
diversification is the most important component to helping you reach your long-range
financial goals while minimizing your risk. Keep in mind, however that no matter how
much diversification you do, it can never reduce risk down to zero. (For related reading,
see Introduction To Diversification and The Importance Of Diversification.)

What do you need to have a well diversified portfolio? There are three main things you
should do to ensure that you are adequately diversified:

1. Your portfolio should be spread among many different investment vehicles such
as cash, stocks, bonds, mutual funds, and perhaps even some real estate.
2. Your securities should vary in risk. You're not restricted to picking only blue chip
stocks. In fact, the opposite is true. Picking different investments with different
rates of return will ensure that large gains offset losses in other areas. Keep in
mind that this doesn't mean that you need to jump into high-risk investments such
as penny stocks!
3. Your securities should vary by industry, minimizing unsystematic risk to small
groups of companies.
Another question people always ask is how many stocks they should buy to reduce
the risk of their portfolio. The portfolio theory tells us that after 10-12 diversified
stocks, you are very close to optimal diversification. This doesn't mean buying 12
internet or tech stocks will give you optimal diversification. Instead, you need to
buy stocks of different sizes and from various industries.

What Is Diversification?
When we talk about diversification in a stock portfolio, we're referring to the attempt by
the investor to reduce exposure to risk by investing in various companies across different
sectors, industries or even countries. Most investment professionals agree that although
diversification is no guarantee against loss, it is a prudent strategy to adopt towards your
long-range financial objectives. (see The Importance of Diversification.) There are many

46
studies demonstrating why diversification works, but this would involve delving into
lengthy arcane financial formulas. Put simply, by spreading your investments across
various sectors or industries with low correlation to each other, you reduce price volatility
by the fact that not all industries and sectors move up and down at the same time or at the
same rate. This provides for a more consistent overall portfolio performance.

It's important to remember that no matter how diversified your portfolio is, your risk can
never be shrunk down to zero. You can reduce risk associated with individual stocks
(what academics call unsystematic risk), but there are inherent market risks (systematic
risk) that affect nearly every stock. No amount of diversification can prevent that.

Can We Diversify Away Unsystematic Risk?

So, up until this point this article has begged the question: how many stocks should you
own to be diversified but not over-diversified? It seems sensible to own five stocks rather
than just one, but at what point does adding more stock to your portfolio cease to
eliminate market risk?

First off, we need to talk about how risk is defined. The generally accepted way to
measure risk is by looking at volatility levels. That is, the more sharply a stock or
portfolio moves within a period of time, the riskier that asset is. A statistical concept
called standard deviation is used to measure volatility. So, for the sake of this article you
can think of standard deviation as meaning "risk".

According to the modern portfolio theory, you'd come very close to achieving
optimal diversity after adding about the 20th stock. In Edwin J. Elton and Martin J.
Gruber's book "Modern Portfolio Theory and Investment Analysis", they conclude
that the average standard deviation (risk) of a portfolio of one stock was 49.2%,
while increasing the number of stocks in the average well-balanced portfolio could
reduce the portfolio's standard deviation to a maximum of 19.2% (this number
represents market risk). However, they also found that with a portfolio of 20 stocks
the risk was reduced to about 20%. Therefore, the additional stocks from 20 to 1,000
only reduced the portfolio's risk by about 0.8%, while the first 20 stocks reduced the
portfolio's risk by 29.2% (49.2%-20%).

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 Many investors have the misguided view that risk is proportionately reduced with
each additional stock in a portfolio, when in fact this couldn't be farther from the
truth. There is strong evidence that you can only reduce your risk to a certain point at
which there is no further benefit from diversification.

True Diversification
The study mentioned above isn't suggesting that buying any 20 stocks equates with
optimum diversification. Note from our original explanation of diversification that
you need to buy stocks that are different from each other whether by company size,
industry, sector, country, etc. Put in financial parlance, this means you are buying
stocks that are uncorrelated – stocks that move in different directions during different
times.

As well, note that this article is only talking about diversification within your stock
portfolio. A person's overall portfolio should also diversify among different asset
classes, meaning allocating a certain percentage to bonds, commodities, real estate,
alternative assets and so on.

Risk and Diversification: Conclusion

Different individuals will have different tolerances for risk. Tolerance is not static, it
will change as your life does. As you grow older tolerance will usually shrink as
more and more obligations come up, including retirement.

There are several different types of risks involved in financial transactions. I

hope we've helped shed some light on these risks. Achieving the right balance
between risk and return will ensure that you achieve your financial goals while
allowing you to get a good night's rest.

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Preventing Unsystematic Risk

Unsystematic risk is the risk you take on when investing in a stock. Basically it is the risk
of some new announcements, or earnings reports coming out that could affect the price of
the stock.

So if you buy a stock thinking it was a good buy and all of a sudden the company comes
out with earnings that are far below expectation the stock might react harshly causing you
to lose money because of some unforeseen events.

However there are ways in which you can prevent yourself, or lessen your chances of
taking unforeseen losses.

If you are an investor and are holding for the long term one thing you can do is to buy
many different companies. If you only have 1 stock and some bad news comes out about
that stock it will drastically affect your portfolio.

However if you have 20-30 different stocks and some bad earnings comes out for one of
your stocks it will not affect your overall portfolio as much. In fact if your other stocks go
up far enough you might actually make money when one of your stocks has a big surprise.

If you are trading stocks there is still the risk of the unforeseen happening. So you should
still be prepared for it by using things like stop losses and risk management.

Another great idea to limit your unexpected risks when trading, is to simply not be in a
stock that is about to give off an earnings announcements. These announcements come
out every 3 months or so and can really move the price of the stock (in either direction).

So it can be a good idea to avoid being in during these times. There will always be
positions out there that you can take without having to worry about earnings.

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 Conclusion

Different individuals will have different tolerances for risk. Tolerance is not static, it
will change as your life does. As you grow older tolerance will usually shrink as
more and more obligations come up, including retirement.

There are several different types of risks involved in financial transactions. I

hope we've helped shed some light on these risks. Achieving the right balance
between risk and return will ensure that you achieve your financial goals while
allowing you to get a good night's rest.

Diversification helps to diversify away unsystematic risk. When the investor has more
than thirty stocks in his portfolio, and all the stocks come from different sectors, he
has diversified away the unsystematic risk. Anything happens to one company is not
likely to wipe out his entire portfolio.

Many bank regulatory actions have been double-edged, if not counterproductive.

With regard to systemic risk, circumstances may exist in which complete
reliance cannot be placed on private ordering; however, excessive reliance on
deposit insurance and other government safety-net measures, even if well
intentioned, has been very costly. Our purpose in this article has been to
emphasize some of those costs and to urge bank regulators to be more sensitive
than they often have been to how their actions can impair private-market
incentives and thus reduce the benefits of their actions. Indeed, we suggest a
deliberate strategy of seeking to minimize the scope of the government’s backup
role and to maximize the effectiveness of private actors as the first line of
defense against systemic risk. That approach was not much in evidence through
the latter two-thirds of the twentieth century. It is not possible either
theoretically or empirically to draw up a comprehensive balance sheet of all the
benefits and costs produced by bank regulation and intervention over that
period, but, in our own view, it is arguable that the costs outweighed the
benefits, and the regulators may well have contributed to systemic risk as much
as they retarded it. We hope that a new strategy that reduces potentially
counterproductive government policies will play a larger role in the twenty-first
century.

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 Bibliography

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