1) ii. The total risk is composed of systematic risk and unsystematic risk. The total risk can be identified into two components, the systematic risk and the unsystematic risk. The systematic risk is the risk that influences a large number of assets. It is also called market risk. On the other hand, the systematic risk is the risk that influences a single company or a small group of companies; also called unique risk or firm-specific risk. The traditional sources of risk that causes variability in returns are categorized by the modern investment analysis into two general types.
The first was those which are pervasive in nature, a general or market component. Examples of this are market risk or interest rate risk. The other component is specific or issuer component. Examples of this are business or financial risk. We then have systematic risk and nonsystematic risk by dividing the total risk into its two components (Anonymous 2007a). The definitions of systematic risk and nonsystematic risk can be compared using a table. Table 1 shows the comparison of the two components. TYPES OF RISKSYSTEMATIC RISKUNSYSTEMATIC RISKPervasive in nature(e. g.
market risk, interest rate risk)Specific to a particular security issue (e. g. business risk, financial risk)General component (market)Specific component (issuer)SYSTEMATIC RISKUNSYSTEMATIC RISKNon-diversifiableDiversifiableattributable to broad macro factors affecting all securitiesattributable to factors unique to a securityTable 1. A Comparison between Systematic Risk and Unsystematic RiskThe overall changes in the general market or economy affects the variability in the security’s total returns. This can be classified also as systematic risk or market risk. We can see that all securities have some systematic risk. For example, if an investor invests whether on bonds or stocks.
There is a systematic risk on it because it directly includes the interest rates, market, and inflation risks. These risks cannot be avoided. Even if the investor tries to diversify or focus on other investments, he cannot escape this risk. That’s because the overall movement in the market covers these risks. If the stock market falls, most stocks will be unfavorably affected, but if it rises, the value of the stocks also rises. Whatever a single investor does, the movements in the stock market will occur. That makes market risk critical to every single investor. The unsystematic risks, however, is unique to a particular security.
The overall market variability do not associate the variability in a security’s total returns. What associates it are such factors like business risk and financial risk. The total risk is the sum of the systematic risk and the unsystematic risk. In equation: TOTAL RISK = GENERAL RISK + SPECIFIC RISKTOTAL RISK = MARKET RISK + ISSUER RISKTOTAL RISK = SYSTEMATIC RISK + UNSYSTEMATIC RISKThe simplest and possibly the most accurate was to describe risk is “the uncertainty of a future outcome”.
That uncertainty can be measured. There are ways to measure the systematic and unsystematic risks. One way to measure this uncertainty or risk is by standard deviation. The return of an investor upon investing is not known, but it can be estimated. Here is an example of a “point estimate”, the total return (TR) on a particular security on an investor may be expected as 10 percent for the coming year (Anonymous 2007a). Where: E(r) is the expected return,