Unit 6: Types of Risk (Systematic and Non-Systematic) Flashcards
Systematic Risks
1) What is Systematic Risk?
2) What are the types of systematic risks?
3) How can investors mitigate systematic risk?
1) Systematic risks are risks that are caused by changes in the overall economy that impact all kinds of securities. You cannot mitigate systematic risk through portfolio diversification. No matter how diversified a portfolio may be, it will be exposed to systematic risks.
2) The different kinds of systematic risks are:
a) Market risk : Refers to the risk that is taken on given the changes in a market. No matter how many stocks or how diversified, stocks are exposed to market risk.
b) Interest rate risk : is the risk that comes from changes in the economy’s interest rates. In money markets, and other debt securities markets, changes in interest rates have consequences on bond prices and yields. If the federal reserve increases interest rates, already existing bonds will be sold at discount because their lower coupon rate is less desirable. Whereas if they decrease rates, then bonds would be sold at premiums because the higher interest rate is more desirable. So, bond prices and interest rates have an inverse relationship. Also, Bond prices of longer maturities will be more volatile with changing interest rates because the interest rate changes are longer lived.
c) Reinvestment risk : this is considered a variation of interest rate risk. When interest rates decrease, issuers will calls the bonds before maturity. The investors not only lose the interest income, but ALSO, now have to purchase lower yielding bonds. Also, bonds with higher interest rates and longer maturities will have higher reinvestment risk.
c) Inflation (purchasing power) risk : Refers to when the coupon rate of a bond is lower than that of the current inflation rate. This means that the coupon payments being made have lower value, and over a long period of time, can amount to huge losses in purchasing power.
3) Investors can mitigate systematic risk by purchasing securities that will move the opposite way of your currently owned securities when the market dips. You can purchase derivative securities such as options to hedge against systematic risk. You cannot mitigate systematic risk through portfolio diversification
Non-Systematic Risks
1) What are non-systematic risks?
a) What is Beta?
2) What are the types of non-systematic risks? (11)
3) How can investors mitigate non-systematic risk?
1) Non-systematic risks refer to risk that can be mitigated through portfolio diversification. These are risks that are unique to industries or specific businesses or specific investment types.
a) Beta is a number that measures the volatility of a security/asset. Beta uses an index as a proxy and tells you how volatile a security is compared to the market, represented by its proxied index. A beta of 1 or higher means the company stocks are more volatile than the market and therefore considered more risky. And vice versa.
2) Types of non-systematic risks :
1) Default Risk
2) Business Risk
3) Financial risk (mostly for debt leveraged companies)
4) Call risk
5) Prepayment Risk
6) Regulatory risk
7) Legislative Risk
8) Political Risk
9) Sovereign Risk
10) Currency Risk
11) Liquidity Risk
3) Investors can mitigate non-systematic risk by diversifying portfolios.
