Systematic Risk, Research Paper Example

When dealing with personal and corporate finances, there are several considerations that must be taken in order to determine the affordability, profitability and overall risk of any investment opportunity.  One particular consideration of investments, pricing and financing is called systematic risk which is also known as market risk or un-diversifiable risk.  This risk has many particular characteristics, but most notably it is directly related to the market as opposed to nonsystematic risk which can be countered by diversification and relies on other criteria outside of the overall market or specific segment of industry.  Given these unique characteristics, they must be carefully analyzed and taken into consideration when developing pricing strategies for products as well as for individuals and corporations to put together a strong portfolio which include variance and diversification, each of which are two characteristics that are not directly related to systematic risk.  Understanding the effects of systematic and nonsystematic risks are important and should be applied by financing managers for investment and financing opportunities.

One important characteristic of systematic risk is that it is immune to diversification in a portfolio.  While nonsystematic risk can often be countered through diversification in a portfolio, systematic risk is consistent and will exist regardless of diversification of stocks and investments within a portfolio.  Diversification often is a useful technique to institute a fair amount of variance within a portfolio which will reduce the amount of risk.  This is the case because diverse stocks will come with alternate amounts of risk where some investments will have higher risk and others with lesser risk.  Oftentimes, it is customary that those investment opportunities with the higher risk should also possess the ability to yield a greater return on investment.

Due to the fact that systematic risk is immune to diversification, it is a risk that is applicable to the entire market or a given market segment.  Systematic risk is directly related to the market and therefore adjusts as the strength of the market increases or decreases.  For instance, an oil company’s systematic risk would be directly related to the sales of fossil fuels and gas – the market segment associated with the investment.  For outside investors, this risk is inherent with the investments and due to the stock or bond’s direct relationship to the market in which the company operates, the individual portfolio of the investor will be impacted by the risk regardless of how other stocks perform.  Oftentimes this is a risk that cannot be directly controlled by the company or organization; it can be controlled and responded to by higher organizations such as governments.  This is directly related to the un-diversifiable characteristic as previously noted.  While this is true for systematic risk, nonsystematic risk is directly related to characteristics other than the direct correlation of the market.  The strength or weaknesses of operational performance and efficiency can impact the nonsystematic risk factors of an individual’s portfolio.  Due to this unique characteristic, the nonsystematic risk can be countered through diversification and strong investors will have a diverse portfolio so that investments with higher nonsystematic risk are countered by investments with less nonsystematic risk.

Finally, the systematic risk is directly related to reducing the overall volatility experienced within the financing and investment operations.  Volatility is the measure of uncertainty or risk in the future price of an asset, which is normally calculated by the standard deviation or variance of the returns on an investment ( ).  Systematic risk is not reflective upon the standard deviation as it is un-diversifiable and inherent within the economy or market.  Nonsystematic risk is associated with factors that can directly influence standard deviation; therefore, systematic risk reduces the volatility of investments within a portfolio.

Works Cited

“What Is Systematic Risk?” Web log post. Noble Trading. 12 May 2008. Web. 20 Nov. 2010. <http://blog.nobletrading.com/2008/05/what-is-systematic-risk.html>.

Schnapp, Frank. “Pricing for Systematic Risk.” 11th Annual AFIR Colloquium (2004): 459-76. Casualty Actuality Society. 2004. Web. 20 Nov. 2010. <http://www.casact.org/pubs/forum/04fforum/04ff459.pdf>.

Thompson, H. E. “Portfolios and Systematic Risk.” Lecture. Fusion Technology Institute – University of Wisconsin. Sept. 1997. Web. 20 Nov. 2010. <http://fti.neep.wisc.edu/neep602/FALL97/lecture34.pdf>.