1.0 IntroductionRisk in finance occurs when investors are faced with uncertainty in relation to the returns of their investments. An investor must ensure that a balance exists between the risk and returns in order to avoid financial loss. Maheshwari (2008) notes that all investors desire to maximize their returns while at the same time they aim at minimizing the risks that are associated with their investments. Investor must identify the appropriate techniques to utilize so as to manage the risks associated with their investments. The fact that some investments are more risky than others require the investors to measure the risk associated with their investments in order to determine the minimum expected returns.
Moreover, the investors must come up with methods of minimizing their risks. Therefore, this paper is going to identify the methods used by investors to analyze and manage systematic and unsystematic risks. In addition, the paper will show how systematic and unsystematic risks affect share prices. 2.0 Systematic and unsystematic RisksAccording to Moyer, McGuigan and Kretlow (2008) systematic risk refers to that risk that cannot be diversified.
Systematic risk occurs due to the variability of a portion of a security returns and this is caused by factors that affect the market as a whole and thus the risk is non-diversifiable. The factors include changes in interest rates, changes in the performance of the economy and changes in the purchasing power as a result of inflation. On the other hand, unsystematic risk refers to that risk that the investor can reduce through diversification. Unsystematic risk can be caused by factors like strikes, management competencies, and competition.
3.0 Methods of analyzing systematic and Unsystematic RiskSystematic risk is of high importance to an investor because it cannot be reduced through diversification (Periasamy, 2009). Investors in the share markets measure the systematic risk before they make their investment decisions. 3.1Beta Analysis Puxty and Dodds (1998) note that systematic risk of a security can be measured statiscally by the use of Beta which analyses the volatility of a stock. Beta is used to measure how the price of a stock responds to price movements in the market. Through the use of beta investor in the share markets are able to determine how the systematic risk of a stock is correlated with the price changes in the stock market as a whole (Periasamy, 2009).
The beta explains how the returns on a market portfolio investment are correlated to a given stock. Sheeba (2009) states that beta can be calculated using the covariance method or the regression method. 3.11 Covariance MethodThe risk of the stock can be measured by the use of standard deviation which measures the covariance of the stock as compared with that of the market.
In this case, the beta of a stock is calculated using historical data whereby the returns of the stock as well as those in the stock market index are used. Using this method, the beta of the stock is represented by the covariance between the returns of the given stock and that of the market index.