Risk | What is Risk? Types of Risk - Systematic Risk and Unsystematic Risk : Know the Concept - financebrother

What exactly is risk? 

Risk basically refers to uncertain or unfavorable future events which negatively impact on our expected return. It is basically future uncertainty which generally taken by investors to realize gains on their investments. It is also involved even in risk-free investment securities as they also have the reinvestment risk, interest rate risk and default risk associated with them. Hence, they are also not completely risk-free.

Risk Categories:

Generally, there are two types of risk involved in portfolio evaluation:

1. Systematic Risk 

2. Unsystematic Risk  

Systematic Risk
Systematic risk is that part of the total risk that is caused by factors beyond the control of companies. This cannot be diversified by creating an efficient portfolio or by holding a large number of securities. It is caused by macroeconomic factors such as political, social, cultural, economic, etc.

Systematic risk generally includes the following types of risk:

• Interest Rate Risk

If there is a rise in the general interest rate, the associated cost of capital will go up for all companies. Hence, companies generate a lower than expected rate of return.

• Market Risk

This refers to general sentiments of the market, like the downward (Bearish Trend in the market at the time of the Sub-prime Crisis, Covid Pandemic, etc.)

• Inflation/Purchasing Power Risk

High inflation rates can reduce the purchasing capacity of consumers and investors, resulting in a decrease in demand in the market and lower profitability for all companies.

Unsystematic Risk
Unsystematic Risk is that part of the total risk which is caused by the internal factors of the companies. This risk can be diversified by creating an efficient portfolio or by holding a large number of securities. It is caused due to internal business circumstances which can be controlled by the companies through efficient internal management.

Unsystematic risk generally includes the following types of risk:

• Business Risk includes:

a) Managerial Efficiency
If the company’s management is taking inefficient decisions which are unfavorable to the company and impact its business performance.

b)Fluctuations in Sales
If there are frequent fluctuations in sales due to improper supply chain management, it may affect the future business performance of the organization.

c) Availability of raw material
Proper availability of raw materials is required to perform uninterrupted business operations. The current example is a shortage of semiconductor chips which interrupts the EV segment growth.

d)Labor Problems
Availability of skilled labor is required to maintain the quality of the products and services. There are some other reasons also, like strikes, health issues, etc. related to labor problems.

e)Changes in consumer preferences.
Preferences of the consumer will frequently change with the change in the price of goods and services. If the price of tea increases, consumers will switch towards the consumption of the coffee.

f)Technological changes
Businesses will only survive when they follow technological changes and update their products and services as per the recent technologies preferred by the consumers. Nokia's mobile manufacturing company became out of competition because it did not follow technological changes and consumer preferences.

• Financial Risk

It is linked to the capital structure of the company. Increase the proportion of fixed-cost capital, such as debt, preferred stock, and so on. The higher the fixed cost bearing capital in the capital structure of a company, the higher the degree of financial risk for the company.

Measurement of Risk or Quantitative Analysis of Risk

Following are the tools used to predict the risk associated with a portfolio:

Total Risk
To predict total risk, we use standard deviation and variance for absolute measures and coefficient of variation for relative measures.

Systematic Risk
We use beta, the correlation coefficient, and the coefficient of determination to predict systemic risk.

Unsystematic Risk
To forecast unsystematic risk, we examine: Alpha and Correlation Coefficient also calculate by:
Unsystematic Risk = Total Risk - Systematic Risk