2.18 Systematic Risk

Understanding investment risk is essential for the SIE exam. Risks are categorized into two main types: systematic (market) risk and unsystematic (company-specific) risk. This section covers systematic risk - the risk that affects the entire market and cannot be eliminated through diversification.

What Is Systematic Risk?

Systematic risk (also called market risk or non-diversifiable risk) affects all securities in the market simultaneously. It stems from factors that impact the entire economy or financial system.

Key Characteristics

Scope: Affects entire market

Diversifiable? No - cannot be eliminated

Examples: Recessions, interest rate changes, inflation

Measurement: Beta

Compensation: Investors are compensated for bearing this risk

Key Concept: You cannot diversify away systematic risk. Even a perfectly diversified portfolio is exposed to market-wide risks.

Types of Systematic Risk

Market Risk

Market risk is the risk that the overall market will decline, causing most securities to lose value regardless of their individual merits.

- Stock market crashes affect virtually all stocks

- Bear markets impact the entire equity market

- External shocks (wars, pandemics) can trigger market-wide declines

Interest Rate Risk

Interest rate risk is the risk that changes in interest rates will affect investment values.

Rates rise: Effect on Bonds - Prices fall; Effect on Stocks - Often negative

Rates fall: Effect on Bonds - Prices rise; Effect on Stocks - Often positive

Most affected: Long-term bonds and preferred stocks are most sensitive to interest rate changes.

Remember: Bond prices and interest rates move in opposite directions.

Inflation Risk (Purchasing Power Risk)

Inflation risk is the risk that rising prices will erode the purchasing power of investment returns.

Fixed-rate bonds: Poor - fixed payments lose value

TIPS: Good - principal adjusts with CPI

Stocks: Moderate - companies can raise prices

Cash: Poor - loses purchasing power

Example: A bond paying 4% interest provides negative real return if inflation is 5%.

Currency Risk (Exchange Rate Risk)

Currency risk affects investments denominated in foreign currencies.

- If foreign currency weakens against USD, investment loses value

- If foreign currency strengthens against USD, investment gains value

- Affects ADRs, international funds, and foreign bonds

Political Risk

Political risk is the risk from government actions, policy changes, or political instability.

- Tax law changes

- Regulatory changes

- Government instability

- Trade policies and tariffs

Reinvestment Risk

Reinvestment risk is the risk that cash flows must be reinvested at lower rates.

- Most relevant when interest rates are falling

- Affects bondholders when bonds are called

- Also affects coupon payments that must be reinvested

Measuring Systematic Risk: Beta

Beta measures a security's volatility relative to the overall market (typically the S&P 500).

Beta Values Interpretation

Beta = 1.0: Moves with the market; Average risk

Beta greater than 1.0: More volatile than market; Above average risk

Beta less than 1.0: Less volatile than market; Below average risk

Beta = 0: No correlation with market; No market risk

Beta less than 0: Moves opposite to market; Negative correlation

Beta Examples

Stock A: Beta 1.5; 50% more volatile than market

Stock B: Beta 0.8; 20% less volatile than market

Stock C: Beta 1.0; Same volatility as market

Stock D: Beta 2.0; Twice as volatile as market

Example: If the market rises 10% and a stock has beta = 1.5, the stock would be expected to rise 15%. If the market falls 10%, the stock would fall 15%.

How Systematic Risk Affects Portfolios

The Risk-Return Trade-Off

Investors expect compensation for taking systematic risk:

- Higher systematic risk, higher expected return

- Lower systematic risk, lower expected return

- The market rewards investors for bearing risk they cannot eliminate

Capital Asset Pricing Model (CAPM)

CAPM states that expected return is based on systematic risk (beta):

Expected Return = Risk-Free Rate + Beta x (Market Return minus Risk-Free Rate)

Where Risk-Free Rate = R-f, Beta = beta, and Market Return = R-m.

Exam Note: You do not need to calculate CAPM, but understand that higher beta = higher expected return.

Systematic Risk Cannot Be Diversified

Buying more stocks: Reduces Systematic Risk? No

Diversifying across sectors: No

Investing internationally: Partially

Hedging with derivatives: Yes (but costly)

The only ways to reduce systematic risk exposure are:

- Reduce equity allocation (shift to bonds/cash)

- Use hedging strategies (options, futures)

- Accept lower returns for lower risk

Key Takeaways

- Systematic risk affects the entire market and cannot be diversified away

- Main types: market, interest rate, inflation, currency, political, reinvestment

- Beta measures systematic risk relative to the market

- Beta greater than 1 = more volatile; Beta less than 1 = less volatile

- Investors are compensated for bearing systematic risk

- Only hedging or reducing market exposure can lower systematic risk