Systematic Risk. There are a number of risks a business organization is exposed to, like ‘Market Risk’, ‘Interest Rate Risk’, ‘Country Risk’, ‘Business Risk’, ‘Financial Risk’, etc. They can be put under two broad categories:
- Systematic Risk
- UnSystematic Risk
Systematic Risk
The risk, which is inherent to the entire market or system, is termed a ‘Systematic Risk’ or ‘Uncontrollable Risk’. It is also referred to as “Un- diversifiable Risk,” as it affects the entire market and not one specific stock or industry. Further, it is associated with the economic, social, political, and legal aspects of all the securities in the economy. These factors are capable of exerting pressure on all securities in the market in such a manner that all of them would move or change accordingly. During a period of economic upswing, prices of all the securities would move northwards, whereas, during a recession period, prices of all the securities would move southwards.
‘Systematic Risk’ is unpredictable and avoiding it is next to impossible. It cannot be mitigated through diversification but can be managed only through the right asset allocation strategy.
Components of Systematic Risk
‘Systematic Risk’ is a broad category of risk and may be classified into the following sub-categories:
1) Market Risk:
Market risk is the risk that the value of an investment will decrease due to movements in market factors. The reason for such uncertainty is market forces represented in two markets, viz. ‘Bull Market’ and ‘Bear Market’. When the economy is booming and other factors and sentiments are positive, the ‘Security Index’ has a tendency to move upward and keeps on moving upwards for a considerable period of time. This is a typical ‘Bull Market’. ‘Bear Market’, on the other hand, is characterized by a tendency of the ‘Security Index’ to decline from the peak of the Bull Market’ to a lower level. The lowest point of ‘Bear Market’ is termed the “Trough’ and it is from this point that economic recovery or ‘Bull Market’ starts.
The market is influenced by a number of factors/events. some of which are ‘Tangible’ while others are ‘Intangible’. Tangible factors are real setbacks like war, famine, volatility in currency, earthquakes, etc. Intangible factors are not real events but are sentiment driven and at times sequel to a tangible event. They are capable of driving the market in either direction.
2) Interest Rate Risk:
Interest rate risk is the possibility of an unexpected change in interest rates prevailing in the market, which affects the value of an investment adversely. Generally, the value of debt instruments like bonds, debentures, commercial papers, etc. is directly affected by ‘Interest Rate Risk. The movements in market interest rates are prompted by the ‘Monetary Policy of the ‘Central Bank of the country (viz. Reserve Bank of India), which leads to changes in
Interest rate risk is the possibility of an unexpected change in interest rates prevailing in the market, which affects the value of an investment adversely. Generally, the value of debt instruments like bonds, debentures, commercial papers, etc. is directly affected by ‘Interest Rate Risk. The movements in market interest rates are prompted by the ‘Monetary Policy of the ‘Central Bank of the country (viz. Reserve Bank of India), which leads to changes in
the interest rates of Treasury Bills’ and ‘Government Bonds’. Bonds issued by the ‘Central / State Government’ ‘Quasi- or Government bodies are regarded as risk-free, although they carry a low-interest rate, in comparison to ‘Private Sector’ or ‘Corporate’ bonds. If they offer a higher rate of interest on their bonds, investors would find them more attractive in view of the inherent level of safety, and perhaps may prefer to shift their investment from ‘Corporate/Private Sector Bonds’ to the papers issued by ‘Central/State Government’ or ‘Quasi-Government’ bodies. Similarly, if the Central or State Government issues new loans bearing a higher rate of interest, there would be a reduction in the value of the existing Government papers, due to the switch of funds from low-interest-bearing bonds to high-interest-bearing bonds.
3) Purchasing Power Risk:
‘Purchasing power risk’ is the possible reduction in the purchasing power of the expected returns. Due to a high rate of inflation, there is erosion in the purchasing power of money, which results in a decrease in the returns. An increase in the rate of inflation is swifter than an increase in the value of the investment. This results in punishment to the investors in the form of reduced return on their investment.
The rising rate of inflation poses a threat to the investor as it is a risk or possible loss for him. Inflation may be a ‘Demand Pull’ (characterized by an increase in aggregate demand and supply cannot keep pace with the demand) or a Cost Push’ (characterized by a reduction in the supply of goods and services, due to increased cost of production).
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