Systemic Risk – Definition

Systematic Risk Definition

Systematic risk is a market risk that affects the entirety of the market, including industries, stocks and other markets.This risk is the vulnerability or volatility that affects the market. The systematic risk is the liability of markets, industries, stocks and assets to change rapidly and unpredictably, especially for the worse. It affects market incomes, outcomes and even market returns. Although, this market risk is unavoidable but it can be mitigated through diversified strategies which include hedging and correct asset allocation.

A Little More on What is Systematic Risk?

Systematic risk come in diverse forms, it can be through market investments and through other market indices. Systematic risk come along with other risks such as recession, inflation of market and stock prices, interest rate changes, wars and many others. Systematic risk alongside the above listed risks lead to volatility of markets which negatively impairs or affects the entire market.

Despite that systematic risk is difficult to predict or avoid, it can be managed. For instance, if investors select a diversified range of asset classes, the effect of market risk can be minimized. This is because each asset class has distinct reaction to market changes.

The Great Recession in 2008 which featured drastic and negative changes in market values is an instance of market or systematic risk. During the Great Recession, asset classes witnessed huge amount of risks and negative changes. A look at a security of portfolio’s beta will help discover whether the security or portfolio is heading towards investment volatility and systematic risk or otherwise. A beta measures how vulnerable an investment is when compared to the entire market. You can have a beta greater than 1, less than 1 and equal to 1, these all have different meanings. Unlike systematic risk that affects the entire market, unsystematic risk affect specific assets, securities, and stocks.

References for Systemic Risk

Academic Research on Systematic Risk

Is the risk of bankruptcy a systematic risk?, Dichev, I. D. (1998). the Journal of Finance, 53(3), 1131-1147. There are many risks that have been listed to be connected with systematic risk such as recession and inflation. This paper investigates whether the risk of bankruptcy is also a systematic risk. Bankruptcy risk is a natural proxy for firm distress because it is a reaction to a firm’s volatility or vulnerability. This paper carried out investigations into the nature of bankruptcy risk in order to detect if it is a systematic risk. It studies the association between bankruptcy risk and subsequent realized returns as well as distress factors that lead to bankruptcy risk. The outcomes of this study and evidence are presented in this paper.

The effect of the firm’s capital structure on the systematic risk of common stocks, Hamada, R. S. (1972). The journal of finance, 27(2), 435-452. A firm’s capital structure refers to how a firm uses diverse kinds of funds to finance its operations and growth. The sources of funds include debts and equity used by a firm for its managerial operations. A firm’s capital structure reflect on the systematic risk of common stocks. This paper examines how firm’s capital structure influences, impacts or affects the systematic risk of common stocks.

Systematic risk management approach for construction projects, Al-Bahar, J. F., & Crandall, K. C. (1990). Journal of Construction Engineering and Management, 116(3), 533-546. Just like any other projects, construction projects face apparent risk during their life cycle. This risks however need to be managed so that a construction project can achieve its quality, time and budget goals. This paper examines a systematic risk management approach for construction projects. Construction risk management system (CRMS) is a risk model that was introduced to help project managers or  contractors identify project risks. Not only will CRMS identify project risks but also help project managers systematically to analyze and manage them. This paper further outlines alternative risk management strategies which are risk avoidance, risk retention, risk retention, risk prevention, insurance and others.

Systematic risk of the multinational corporation, Reeb, D. M., Kwok, C. C., & Baek, H. Y. (1998). Journal of International Business Studies, 29(2), 263-279. Systematic risk cannot be predicted or avoided, it can only be mitigated of managed. Multinational corporations are also faced with systematic risk, they are able to reduce this risk through diversification or correct asset allocation strategy. This paper examines systematic risk in multinational corporations, it studies factors that increase or decrease this risk. This article identifies that systematic risk of multinational firms is likely to increase as a result of increased standard deviation of cash flows. This paper presents significant evidence about the relationship between systematic risk level of a multinational corporation and firm’s internalization.

Systematic risk, hedging pressure, and risk premiums in futures markets, Bessembinder, H. (1992). The Review of Financial Studies, 5(4), 637-667. Systematic risk is a market risk that affect the entirety of market negatively, it affects industries, stocks and assets as well. Previous studies presented ways to mitigate systemic risk by a means of diversification which is usually in form of hedging or by using correct asset allocation strategy. This paper however discusses the tendencies of systematic risk, hedging pressure and risk premiums in future markets. It presents a test as against the general alternative that does not integrate future markets in the discussion of systematic risk, hedging pressure and risk premiums. It also examines the uniformity of risk pricing in futures and asset markets.

Diversification strategy and systematic risk, Montgomery, C. A., & Singh, H. (1984). Strategic Management Journal, 5(2), 181-191. There are certain ways through which systematic risk can be mitigated, this include diversification. This paper examines the interplay between diversification strategy and systematic risk (beta). It discusses a market risk analysis of the relationship between diversification strategy and systematic risk. According to beta values, a beta value greater than 1 means the investment has more systematic risk than the market, while less than 1 means less systematic risk than the market. A beta equal to 1 means the same systematic risk as the market. This paper also examines beta values using six diversification categories. It also explores market power, capital structure and capital intensity.

Multiscale systematic risk, Gençay, R., Selcuk, F., & Whitcher, B. (2005). Journal of International Money and Finance, 24(1), 55-70. This journal discusses the multiscale systematic risk, it presents a new model or an approach to how systematic risk can be estimated. Systematic risk basically show the beta of a stock or an asset and this has overall effects on markets as it even leads to vulnerability of market. The new approach discussed in this journal stems from wavelet multiscaling approach, this multiscale approach dissolve time series using a scale-by-scale method. The discussion in this journal also resulted from empirical findings that the interaction between the return of a portfolio and its beta is strengthened when wavelet scale increases. This journal also treats the CAPM model in line with multiscale tendency of risk and return.

The theoretical relationship between systematic risk and financial (accounting) variables, Bowman, R. G. (1979). The Journal of Finance, 34(3), 617-630. This paper presents a study on the theoretical relationship between systematic risk, financial variables and market based measures of risk. Given the empirical research conducted in this regard, this paper finds out that certain accounting variables have a link with beta, a market based measure of risk. This correlation between these two is regarded as a useful tip in the prediction of future market risks. Other empirical researches on the relationship between financial variables and market based measures of risk are also discussed. However, the aim of this paper is to provide a theoretical basis for empirical research into this relationship.

Systematic risk, total risk and size as determinants of stock market returns, Lakonishok, J., & Shapiro, A. C. (1986). Journal of Banking & Finance, 10(1), 115-132. The determinants of stock market returns which include systematic risk, total risk and market size are discussed in this paper. It studies the historical relationship between stock market returns, market variables and financial variables between 1962-1981. This paper explores empirical work recently done in 1982 by Banz and Reinganum and the findings of this work regarding stock market returns. The capital asset pricing model (CAPM), which posits a specific relationship between systematic risk (beta) and required asset returns is also explored. This paper however conclude that size really matters in the explanation of the cross-sectional variation in stock returns.

Collateral damage: A source of systematic credit risk, Frye, J., Ashley, L., Bliss, R., Cahill, R., Calem, P., Foss, M., … & Lobbes, C. (2000). Risk, 13(4), 91-94. This paper examines collateral damage as a source of systematic credit risk, it discusses collateral, collateral value, collateral damage and the systematic credit risk. Using a research conducted on participants at the 1999 FRB-Chicago Capital Markets Conference, this paper examines collateral damage as a source of systematic credit risk. Factors considered in the paper include whether a borrower should default on a loan as a bank’s recovery may depend on the value of the loan collateral. The paper also examines how the value of collateral fluctuates just like the value of any other assets. It discusses factors that lead to obligors default and collateral damage in an economy.

•    Advertising, research and development, and systematic risk of the firm, McAlister, L., Srinivasan, R., & Kim, M. (2007). Journal of Marketing, 71(1), 35-48. In this paper, the impacts of a firm’s advertisement, its research and development (R&D) on the systematic risk of the firm’s stock are examined. These are key metrics for publicly listed firms. This paper use the response of marketing executives on how they use finance to gain internal support for marketing initiatives. Using a panel data on 644 publicly listed firms between 179 and 2001, this paper test an existing hypothesis on firm’s advertising and its research development. The hypotheses state that a firm’s advertising and R&D expenditures create intangible assets that insulate it from stock market changes, lowering its systematic risk. This paper examines issues surrounding it.

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