What is Systematic Securities Risk?
Systematic Securities Risk also known as systemic risk, market risk and un-diversifiable risk is risk which applies to whole market or market segment.
It is opposite to idiosyncratic risk which applies to specific stocks or other financial products. Often systematic risk results in declining of total portfolio investment value as all most portfolio investments declines in value.
Systematic risks often originate from political or economical problems, wars, interest rate changes, and calamities. They are usually hard to avoid; and avoidance. steps should come from higher authorities like governments.
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Usually systematic risks cannot be minimized by diversification of investment in a particular market segment; but may be by investing in different market segments, because the factors causing the risk affect different market segments differently.
The major ways to reduce these risks are avoiding investments, reducing investments and hedging investments.
Systematic risks often trigger a chain reaction in an economy. They necessitate change of plans and strategies by governments, companies, banks, financial markets and individual portfolios.
Systematic risks are also a major cause for failure of banks. The beta value of a stock gives information about the systematic risk it faces. The examples of systematic risk are:
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- The government changes the interest rate policy. The corporate tax rate is increased.
- The government resorts to massive deficit financing.
- The inflation rate increases.
- The RBI promulgates a restrictive credit policy.
- The government relaxes the foreign exchange regulations and announces full convertibility of the Indian rupee.
- The government Withdraws tax on dividend payments by companies.
- The government eliminates/reduces the capital gain tax rate.
The individual components of systematic risk are the following:
- Market risk.
- Interest rate risk.
- Purchasing power risk.
It constitutes to be the-major part of the systematic risk. It can be referred to as a phenomenon of variations in the expectations of the investor in respect of his investment, either due to changes in the return produced/ anticipated from his investment or that produced/anticipated from investments by other investors.
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Market risk is a reaction of the investor to security returns and prices of his own and others.
Interest Rate Risk:
The risk that an investment’s value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship.
Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixed-income securities with different duration’s) or hedging (e.g. through an interest rate swap).
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Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall and vice versa.
The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases since investors -are able to realize greater yields by switching to other investments that reflect the higher interest rate.
For example, a 5% bond is worth more if interest rates decrease since the bondholder receives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates.
Purchasing Power Risk:
The risk that unexpected changes in consumer prices will penalize an investor’s real return from holding an investment. Because investments from gold to bonds and stock are priced to include expected inflation rates, it is the unexpected changes that produce this risk.
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Fixed income securities, such as bonds and preferred stock, subject investors to the greatest amount of purchasing power risk since their payments are set at the time of issue and remain unchanged regardless of the inflation rate.
General risk in prices is seen as inflation while general decline in prices is understood as. deflation. Purchasing power risk includes with these phenomena. These inflation’s are called cost-push and demand-pull.
Demand-pull Inflation is traceable to unfilled demand when the economy is at a full-employment level of operations.
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At this level, supply cannot be readily increased in the short-run until the labor force or production expands. Cost-push inflation stems from increasing costs of production.
As raw material and wage costs rise, produces attempt to pass along these increased costs, through higher prices. The implication of the purchasing power risk is that the investors have to provide for an allowance for the unexpected changes in prices.