Systematic Risk

Definition

Systematic risk refers to the inherent risk that affects an entire market or a segment of the market, which cannot be eliminated through diversification. This type of risk is influenced by factors such as economic conditions, geopolitical events, and changes in interest rates that impact all securities and investments within that market. Understanding systematic risk is crucial when calculating the cost of capital as it helps determine the expected return required by investors to compensate for taking on this unavoidable risk.

5 Must Know Facts For Your Next Test

1. Systematic risk is also known as market risk, as it affects the entire market and cannot be mitigated by diversification strategies.
2. Common sources of systematic risk include economic downturns, political instability, inflation, and changes in interest rates.
3. Investors demand higher returns for bearing systematic risk, which impacts the cost of equity when calculating the overall cost of capital for a firm.
4. The Capital Asset Pricing Model (CAPM) is often used to quantify the relationship between expected return and systematic risk through the use of beta.
5. Portfolio managers must consider systematic risk when constructing portfolios, as it influences investment decisions and overall asset allocation.

Review Questions

• How does systematic risk differ from unsystematic risk in terms of investment strategy?
  • Systematic risk is inherent to the entire market and cannot be eliminated through diversification, while unsystematic risk is specific to individual assets or sectors and can be reduced by holding a diversified portfolio. Investors need to understand that while they can manage unsystematic risk through strategic asset allocation, they must still account for systematic risk in their overall investment strategy. This means they should prepare for market-wide changes and consider how those will affect their portfolio's performance.
• What role does beta play in assessing systematic risk when using the Capital Asset Pricing Model (CAPM)?
  • Beta is a critical component in the Capital Asset Pricing Model (CAPM) as it measures an asset's sensitivity to movements in the overall market. A beta greater than 1 indicates that the asset is more volatile than the market, thus carrying higher systematic risk, while a beta less than 1 suggests lower volatility and lower risk. By incorporating beta into CAPM, investors can calculate expected returns based on the level of systematic risk associated with their investments, aiding in decision-making about capital allocation.
• Evaluate the impact of systematic risk on corporate financial decisions regarding capital structure and financing.
  • Systematic risk significantly influences corporate financial decisions related to capital structure and financing strategies. Companies must assess their exposure to market-wide risks when determining their debt-to-equity ratio, as higher levels of debt may increase financial leverage and exposure to economic fluctuations. Understanding systematic risk allows firms to forecast potential changes in their cost of capital, impacting their investment decisions and overall financial health. Therefore, companies often strive for an optimal capital structure that balances risk and return in light of prevailing market conditions.

Related terms

Beta: A measure of a security's volatility in relation to the overall market, representing the level of systematic risk associated with that security.

Market Risk Premium: The additional return that investors expect to earn from holding a risky market portfolio instead of risk-free assets, which compensates for systematic risk.

Capital Asset Pricing Model (CAPM): A model that establishes a relationship between the expected return of an asset and its systematic risk, allowing investors to assess the risk-return tradeoff.