Macro Risk Levels

On a macro (large scale) level there are two main types of risk, these are systematic
risk and unsystematic risk.
• Systematic risk is the risk that cannot be reduced or predicted in any manner and it is
almost impossible to predict or protect yourself against this type of risk. Examples of this
type of risk include interest rate increases or government legislation changes. The
smartest way to account for this risk, is to simply acknowledge that this type of risk will
occur and plan for your investment to be affected by it.
• Unsystematic risk is risk that is specific to an assets features and can usually be
eliminated through a process called diversification (refer below). Examples of this type of
risk include employee strikes or management decision changes.
Micro Risk Levels
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While the above risk types are the macro scale levels of risk, there are also some more
important micro (small scale) types of risks that are important when talking about the valuation
of a stock or bond. These include:
• Business Risk - The uncertainty of income caused by the nature of a companies business
measured by a ratio of operating earnings (income flows of the firm). This means that the
less certain you are about the income flows of a firm, the less certain the income will
flow back to you as an investor. The sources of business risk mainly arises from a
companies products/services, ownership support, industry environment, market position,
management quality etc. An example of business risk could include a rubbish company
that typically would experience stable income and growth over time and would have a
low business risk compared to a steel company whereby sales and earnings fluctuate
according to need for steel products and typically would have a higher business risk.
• Liquidity Risk – The uncertainty introduced by the secondary market for a company to
meet its future short term financial obligations. When an investor purchases a security,
they expect that at some future period they will be able to sell this security at a profit and
redeem this value as cash for consumption - this is the liquidity of an investment, its
ability to be redeemable for cash at a future date. Generally, as we move up the asset
allocation table - the liquidity risk of an investment increases.
• Financial Risk - Financial risk is the risk borne by equity holders (refer Shares section)
due to a firms use of debt. If the company raises capital by borrowing money, it must pay
back this money at some future date plus the financing charges (interest etc charged for
borrowing the money). This increases the degree of uncertainty about the company
because it must have enough income to pay back this amount at some time in the future.
• Exchange Rate Risk - The uncertainty of returns for investors that acquire foreign
investments and wish to convert them back to their home currency. This is particularly
important for investors that have a large amount of over-seas investment and wish to sell
and convert their profit to their home currency. If exchange rate risk is high - even though
a substantial profit may have been made overseas, the value of the home currency may be
 less than the overseas currency and may erode a significant amount of the investments
earnings. That is, the more volatile an exchange rate between the home and investment
currency, the greater the risk of differing currency value eroding the investments value.
• Country Risk - This is also termed political risk, because it is the risk of investing funds
in another country whereby a major change in the political or economic environment
could occur. This could devalue your investment and reduce its overall return. This type
of risk is usually restricted to emerging or developing countries that do not have stable
economic or political arenas.
• Market Risk - The price fluctuations or volatility increases and decreases in the day-to-
day market. This type of risk mainly applies to both stocks and options and tends to
perform well in a bull (increasing) market and poorly in a bear (decreasing) market
(see bull vs bear). Generally with stock market risks, the more volatility within the
market, the more probability there is that your investment will increase or decrease.

Systematic Risk:
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:
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

Relevant Risk:
As systematic risk is beyond the control of people working in market that;s why it is defenately
not the relevent risk because anything not controllable is irrelevant and that's why unsystematic
risk is the relevant risk because it is in the control of investor to in which security to invest or
not.
Systemic risk refers to the risk or probability of breakdowns in an entire system, asopposed to
breakdowns in individual parts or components, and is evidenced by
comovements (correlation) among most or all the parts.
T h u s , s y s t e m i c r i s k i n 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.I t i s t h e r i s k w h i c h i s d u e t o t h e
f a c t o r s w h i c h a r e b e y o n d t h e c o n t r o l o f t h e p e o p l e 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 i s t h a t c o m p a n y o r i n d u s t r y s p e c i f i c r i s k t h a t i s i n h e r e n t i n
e a c h 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 s e t b a c k i n o n e o f i t s e x p e r i m e n t s , a n d g o e s i n t o h u g e
losses. This event, is
companyspecific, and reduces your wealth. However, if one invests $10,00
0 i n 1 0 d i f f e r e n t biotechnology companies, the probability of wealth reduction due to
unforeseen events or setbacks is reduced considerably. Also known as "specific risk",
"diversifiable risk" or residual risk", this risk can be defined as that part of a risk which is
not correlated with general market movements. T h i s i s t h e r i s k o t h e r t h a n s y s t e m a t i c
risk and which is due to the factors which are controllable by the people
w o r k i n g i n m a r k e t a n d m a r k e t r i s k p r e m i u m i s u s e d t o compensate this type of
risk.

Total Risk = Systematic risk + 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 thingshappening.Investments
have two components that create risk. Risks specific to a particular type
of investment, company, or business are known as unsystematic risks. Unsystematic
riskscan be managed through portfolio diversification, which consists of making investmentsin
a variety of companies and industries. Diversification reduces unsystematic risk
because the prices of individual securities do not move exactly together. Increases
inv a l u e a n d d e c r e a s e s i n v a l u e o f d i f f e r e n t s e c u r i t i e s t e n d t o c a n c e l o n e
a n o t h e r o u t , reducing volatility. Because unsystematic risk can be eliminated by
use of a diversifiedportfolio, investors are not compensated for this risk.Systematic risks, also
known as market risk, exist because there are systemic risks withinthe economy that affect
all businesses. These risks cause stocks to tend to movetogether, which is why investors
are exposed to them no matter how many differentcompanies they own.Investors who are
unwilling to accept systematic risks have two options. First, they canopt for a risk-free
investment, but they will receive a lower level of return.
Higher r e t u r n s a r e a v a i l a b l e t o i n v e s t o r s w h o a r e w i l l i n g t o a s s u m e
s y s t e m a t i c r i s k . 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
desiretheir projects to have rates of return that exceed the risk-free rate to compensate themfor
systematic risks and that companies desire larger returns when systematic risksare
greater.T h e o t h e r a l t e r n a t i v e i s t o h e d g e a g a i n s t s y s t e m a t i c r i s k b y p a y i n g
a n o t h e r e n t i t y t o 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 hasmore 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. Systemati crisk is the risk affecting the entire stock market.
In a recession the prices 4 most cos in d stock mrkt will cum down. Recession is an example of
systematic risk . Mutual funds and index funds are diversified portfolios subjected 2 systematic
risk of d stock mrkt. Fund mgrs do not hve d power 2 reduce systematic risk. Even d govts of d
world , however powerful dey r , cnt stop d country 4rm going in2 recession.

Systematic risk unsystematic risk

Mrkt risk bus risk, financial risk, default risk

Intrst rate risk
Purchasing power risk

Dangers of Systemic Risk

Both the chain-reaction and the common-shock concepts of systemic risk involve
speedycontagion and require some actual or perceived direct or indirect connection
amongthe parties at risk (Kaufman 1994). Banks are connected directly through
interbank deposits, loans, and payment-system clearings and indirectly through
serving thesame or similar deposit or loan markets. In addition, to the extent that banks
operatea c r o s s n a t i o n a l b o r d e r s , t h e y l i n k t h e c o u n t r i e s i n w h i c h t h e y
operate. Thus, an
adverse shock that generates losses at one bank large enough to dr
i v e i t i n t o insolvency may transmit the shock to other banks along the
transmission
chain.Moreover, adverse shocks in the financial sector appear to be trans
m i t t e d m o r e 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.
Itf o l l o w s t h a t t h e t r a n s m i s s i o n a n d d a n g e r o f s y s t e m i c r i s k a r e l i k e
l y t o d i f f e r 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, thisattempt requires them to charge higher in
t e r e s t r a t e s o n r i s k i e r i n v e s t m e n t s , t o monitor their counterparties carefully, to
require more and better collateral, and tohave sufficient capital to absorb any losses
from their association with an infectedbank 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 successfullya n d t o r i n g d o w n o t h e r b a n k s , l o s s e s m u s t
exceed capital at each bank along
t h e chain.B a n k s w i t h s u f f i c i e n t c a p i t a l t o a b s o r b t h e t r a n s m i t t e d l o s s e s w i l l
r e m a i n s o l v e n t , although they may be weakened, and thus will stop the cascading.
The amount of capitalrequired to remain solvent depends on the exposure of a particular bank
to other units andon the expectations regarding the magnitude of any shocks. Both the
exposure and 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 isthe adverse shock required to drive a bank or other institution into
insolvency, nd thegreater 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
todevelop 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 financialsector differs
from most other sectors, where the transmission of adverse shocks isslower and
units generally have time to act to protect themselves after the initialshock has
occurred.Random contagious systemic risk is considered particularly dangerous and
undesirablebecause it spills over to and damages both banks that are perceived to
beeconomicallys o l v e n t a n d t h o s e t h a t a r e c o n s i d e r e d i n s o l v e n t . A l t h o u
g h i t i s r e l a t i v e l y e a s y t o distinguish the solvent from the insolvent after the crisis, it
can be difficult in practiceto 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 withthe active assistance and encouragement of their
governments, frequently fail todisclose relevant information and, especially as they
approach insolvency, tend toprovide insufficient reserves for loan losses and to use
questionable and sometimeseven 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
thedefinition of systemic risk used. Almost tautologically, systemic risk is observed
mostfrequently when it is defined as a big, broad shock. As noted earlier, however, thisdefinition
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 rationaland to be confined primarily to “insolvent”
institutions and not randomly to affectsolvent banks fatally (Kaufman 2000a).W i t h r e s p e c t
to banks, at least in the United States, there is little if any evidence
o f contagious systemic risk that causes economically solvent banks to
becomeeconomicallyo r l e g a l l y i n s o l v e n t , e i t h e r b e f o r e o r a f t e r t h e i n t r o d u c t i o
n of federal governmentguarantees and insurance (Kaufman 1994). U.S. ba
nks have been studied mostthoroughly because of their large number, good
h i s t o r i c a l d a t a , a n d m i n i m u m 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 exclusivelyonly to banks with the same or similar portfolio-risk exposures and
subject to thes a m e s h o c k . T h e r e i s l i t t l e i f a n y e m p i r i c a l e v i d e n c e t h a t t h e
i n s o l v e n c y o f a n individual bank directly causes the insolvency of economically solvent
banks or thatbank depositors run on economically solvent banks very often or that, when they
do,they drive these banks into insolvency.