Question

What are the main differences between unsystematic and systematic risk?

Hint:

To easily remember the difference: Systematic risk affects the entire system (such as a global economic recession), whereas unsystematic risk is a local issue that affects a single company (such as a factory fire). You can diversify away local issues, but you cannot diversify away systemic ones.

Answer 1

Step 1: Core Definitions:

• Systematic Risk (Market Risk): The inherent risk that affects the entire financial market or economy. It cannot be avoided, regardless of how diversified a portfolio is.
• Unsystematic Risk (Idiosyncratic Risk): The firm-specific or industry-specific risk that is unique to a particular stock or sector.

Step 2: Analytical Differences:
The key differences between systematic and unsystematic risk include:
• Diversifiability:
• Systematic Risk: Non-diversifiable. Since it is caused by macroeconomic factors, it affects all assets simultaneously.
• Unsystematic Risk: Diversifiable. It can be reduced or eliminated by holding a well-diversified portfolio of uncorrelated assets.
• Causal Factors:
• Systematic Risk: Driven by macro-level external forces, such as changes in interest rates, inflation, gross domestic product (GDP) contractions, fiscal policy changes, and geopolitical conflicts.
• Unsystematic Risk: Driven by micro-level internal factors, such as product recalls, labor strikes, raw material shortages, corporate fraud, or changes in company management.
• Mathematical Representation and Measurement:
• Systematic Risk: Measured using the Beta ($\beta$) coefficient, which indicates how volatile a specific security is relative to the broader market index: $$\beta_i = \frac{\text{Cov}(R_i, R_m)}{\text{Var}(R_m)}$$
• Unsystematic Risk: Calculated as the residual variance ($\sigma^2_{\epsilon}$) in asset returns that is not explained by market movements under the Capital Asset Pricing Model (CAPM): $$\sigma^2_{\text{total}} = \beta^2 \sigma^2_m + \sigma^2_{\epsilon}$$ Where $\beta^2 \sigma^2_m$ represents systematic risk and $\sigma^2_{\epsilon}$ represents unsystematic risk.
• Investor Compensation:
• Systematic Risk: Since investors cannot diversify away systematic risk, they are compensated for taking it on with a risk premium.
• Unsystematic Risk: The market does not reward investors for taking on unsystematic risk, as it can easily be avoided through proper diversification.