Systematic Risk and Unsystematic Risk - Assignment Example

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 RISK SYSTEMATIC RISK UNSYSTEMATIC RISK Pervasive 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 RISK UNSYSTEMATIC RISK Non-diversifiable Diversifiable attributable to broad macro factors affecting all securities attributable to factors unique to a security Table 1. A Comparison between Systematic Risk and Unsystematic Risk The 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 RISK TOTAL RISK = MARKET RISK + ISSUER RISK TOTAL RISK = SYSTEMATIC RISK + UNSYSTEMATIC RISK The 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, r is the actual return,  is the standard deviation The likely returns and the estimates of probabilities can be manipulated using a standard deviation. The total risk of an asset or a portfolio, both the systematic and unsystematic risk is measured using the standard deviation (Anonymous 2007a). Whatever the source of variability is, the total variability of the return can be described this measuring tool. The total risk of one security or the total risk of a portfolio of securities, therefore, can be measured through the standard deviation of return (Anonymous 2007a). By using also the standard deviation, the total risk related to the expected return, can be calculated. In the probability distribution, it is the measure of the dispersion of a random variable approximately near its mean. There is this relation that the larger this dispersion was, the larger also the standard deviation, the more uncertain the expected outcome. Other way to measure risk is by duration. The formula given by: We can also use duration-based hedge ratio to measure risk. The formula given by: We can also use the Beta coefficient (b). It measures the relative systematic risk of an asset. Assets with Betas larger than 1.0 have more systematic risk than average. Assets with Betas smaller than 1.0 have less systematic risk than average. The larger the beta, the greater the expected return and vice versa. The formula given by: There is a systematic risk of a certain security that cannot be avoided through diversification. The measure of this unavoidable systematic risk is called beta. It is the relation between the risks of an individual stock to the market portfolio of all stocks. Beta also measures a security’s fluctuations in price. To judge a stock’s riskiness, investors practice to use beta. Using this beta, stocks can be ranked in declining order by their betas. The stocks on the top (or with the higher betas) are of more risk than those on the lower part of the ranking. Ranking the stocks with their betas is similar to rank them be their absolute systematic risk. We can also limit the duration and measure the risk. The formula given by: 1) ii. "If we hold a portfolio of stocks we need only consider the systematic risk of the securities". "As a cautious investor we must always consider total risk". "We should not buy anything if the expected return is less than the market as a whole and certainly not if it is below the return on the risk free asset". "If we hold a portfolio of stocks we need only consider the systematic risk of the securities". On the first comment of the director that we only need to consider the systematic risk of the securities when holding a portfolio of stocks, I might have agree with him. There is a systematic principle stating that the reward for bearing risk depends only on the systematic risk of an environment. Regarding what the director said, should only consider the systematic risk of the securities, which is favored also by the systematic principle. And also, assets with greater systematic risk will have greater expected returns. Therefore, only the systematic portion is relevant in determining the expected return on an asset no matter how much total risk that asset has. Although systematic risk decreases diversification, or as I had discussed on the previous pages, that any investor cannot escape this market risk, the loss on investing with systematic is small compared to greater risk of non-diversifiable but in relation with this is also higher expected returns. Remember that assets with betas greater than 1.0 have more systematic risk than average and assets with betas smaller than 1.0 have less systematic risk. And we also already discussed the relation between higher systematic risks. It has a directly proportional relation with the expected return. So the greater are the betas, the more the payoff. Since the nonsystematic risks are only attributed to specific security issue, then we can say that the unsystematic risk is not special when it comes to long-term operations. And to be compensated for the risk, the risk must had been special. Consider a portfolio made up of asset X and a risk-free asset. For asset X, E(RA) = 20% and bX = 1.6 The risk-free rate Rf = 8%. Note that for a risk-free asset, b = 0 by definition. % of Portfolio in Asset X Portfolio Expected Return Portfolio Beta 0% 8 0.0 25 11 0.4 50 14 0.8 75 17 1.2 100 20 1.6 125 23 2.0 150 26 2.4 Using this table as an example, we can see the expected return increases as the beta increases. And the highest expected return (at 26) can be reached when the beta is 2.4 (large enough as a systematic risk). "As a cautious investor we must always consider total risk". This surely must be done. Since the total risk is the sum of the systematic risk and the nonsystematic risk, then it has a big impact on the asset too. Since their company’s surplus fund will be used for a long-term investments (greater than 5 years), then the company should maximize the expected return and have a preference of finding and ordering over all portfolios under some restrictions like the company’s budget, the distribution of yields of each available assets, and the prices this assets are going to cost the company. The company should also consider the different demands of each and every asset they are trying to invest with for the reason simply of the risk each have and also their prices are varying. And during this long-term investment, there are many uncertain things in the market that will have affect the expected return. Such uncertain things are the prices at the stock market that then will lead to uncertain prices over time period, uncertain income, uncertain costs and uncertain business condition. Asset pricing of an asset must be given focus since it is affected by the market and is also crucial regarding the risk of the asset. Like pricing, probability should also be considered. As this word means, the outcomes are uncertain and so risks follows from this uncertainty. But the most fundamental that must be considered and must be given importance, and the most vital challenge, are the preferences of what the company should choose. And all else follow. Together with this uncertainties (e.g. asset pricing, probabilities, and preferences), looking at broader concept, all of this are under systematic and unsystematic risk which are components of the total risk which are vital to the company and to its funds that will be put on an investment portfolio. Therefore, total risk must be considered always since it’s the sum of all the risks the company will take over the period of time of their investment. “We should not buy anything if the expected return is less than the market as a whole and certainly not if it is below the return on the risk free asset”. On our own perspective, we should surely not buy anything if we are only paying more than earning, and should probably not if our earnings is below the expected return. According to the definition, a certain future return of an asset is what is called a risk-free asset. What makes this risk-free is that because the assets are very safe that the returns are very close to what is expected, that is certain. But some scholars say that all financial carry, even in an unnoticeable way, some degree of risk. Because of this, they tell that there is no such thing as a risk-free asset. They are technically correct. But what makes this sound as risk-free, is that the level of risk is too small. Recall that beta (b) is one of the measuring tools to measure the riskiness. For a risk-free asset, b = 0, which implies that the return is certain. Remember that as b increases, the return also increases and vice versa. This shows that preferring a risk-free asset, with certainty, will have its expected return to be not less than the market as a whole, and probably, not below the return. In the case that company was about to make the preference of investing in a risk-free assets, and upon choosing from different portfolio, finds a risk-free asset and have computed the expected return and known to be less than the market, the decision should not to buy that anything from that asset and just try to find another portfolio to invest. And probably, the company should certainly not choose an asset which expected return are below the market. This is just a waste of time and money, and will also delay the cash flow of the company. 2) a. The value calculated using net present value or internal rate of return of the value of future expected cash receipts and expenditures at a common date is the value of the future expected cash receipts, the discounted cash flow (DCF). It is also a factor in analyses of capital investments. DCF is also called capitalization of income. By estimating future cash flows, and taking into consideration the time value of money, an investment can be evaluated using the discounted cash flow. According to the definition of the free dictionary by Farlex, the one I surfed on the internet, discounted cash flow is a valuation method used to estimate the attractiveness of an investment opportunity. To evaluate the potential for investment, and to arrive at a present value, discounted cash flow analyses uses future free cash flow projections and discounts them (Anonymous 2007b). The weighted average cost of the capital is usually used to in discounting. In order to receive the expected cash flow in the future years, what someone is willing to pay today is also one of the definition of the discounted cash flow. The most frequently method used by large investment banks and accounting and consulting firms is the discounted cash flow (DCF). The level or risk of the business and the opportunity cost of capital determines the discount rate. Or simply, by investing your money elsewhere, it is the return you can earn from it. By estimating the expected future cash flows, the value of the company can be measured. To determine the present value of the future cash stream, we then discount those future flows by the desired rate of return In some way, the relative value and asset valuation approaches are limited. The accounting-based indicators such as earnings per share, return on investment and return on equity) may have serious limitation because they are influenced by some factors (Anonymous 2006a). Such factors are inventory accounting and depreciation(Anonymous 2006a). In this case, they do not take into account the following factors: various levels of risk (both business and financial) in different companies; the needed working capital and fixed capital investment for projected sales growth (Anonymous 2006a); dividend policy; and the time value of money, that is the value of the money (dollar for example) today which is worth lesser at the present time compared in the future that will have a greater value because the money we use to invest a return are for short-term only. The importance of discounting the future cash flow is that is can determine the appropriate discount rate and the value beyond short-term forecast period can be established. The relative levels of business and financial risk are reflected through the discount rate. Then this factor is a must. The appropriate discount rate can be derived from the risk-free rate of return, and some premium risk for investing in a business venture (Anonymous 2006a). A short example why would an individual look for opportunities with a minimum of 6% to 8% premium over risk free investments to purchase business that have a high possible rate of success is that because the money they are going to use are borrowed from a risk free rates plus two or three percent that will make their cost of money and required rate of return spread in a very small distribution. 2) b. This is the computation of the investment’s net present value at 12% opportunity cost of capital. The value created from the underlying investment was determined by the net present value (NPV). This is the formula to calculate the Net Present Value (NFV): This equation can be simplified when expressed in mathematical terms: Definition of Terms: Initial Investment is the investment made at the beginning of the project; since most projects involve an initial cash outflow, the value of the initial investment is generally negative. Cash Flow: The net cash flow for each year of the project: it is the amount resulting from Benefits minus the Costs; Rate of Return (r): The rate of return is calculated by looking at comparable investment alternatives having similar risks. The rate of return in our example is an opportunity cost of capital, but usually is often referred to as the discount, interest, hurdle rate, or company cost of capital. Because the company approximates the risk of the project to be on average, the company employs a standard rate for a certain project (Anonymous 2006b). For financial evaluation of long-term projects, Net present value is a standard method to use. The net present value measures the excess or loss of cash flows. The projects are said to be profitable if the net present value is positive. On the other hand, not all positive valued net present value should be undertaken since NPV does not account for opportunity cost(Anonymous 2006b). But in general, investments are acceptable if the NPV are positive. Projects then should only be undertaken if their NPV is greater than the opportunity cost (Anonymous 2006b). In the case of Susie Lee, on whether to undertake the said investment project, I will recommend that she would undertake this project since the net present value is positive. In addition to this, the net present value of the investment project is greater than the opportunity cost. Note: The handbooks used are the following: Business finance (Neale & McElroy 2004) Corporate finance (Watson & Head 1998) Corporate finance and strategy (Pike & Neale 1999) Foundation of corporate success (John Kay, 1993) Read More