Systematic Risk

Understanding Systematic Risk

Systematic risk (also known as market risk, non-diversifiable risk, or undiversifiable risk) is the risk inherent in the entire market or market segment. This type of risk affects virtually all securities simultaneously and cannot be eliminated through diversification.

The key principle to understand is that investors ARE compensated for bearing systematic risk through the market risk premium. This is because systematic risk represents unavoidable exposure that all market participants must accept. The Capital Asset Pricing Model (CAPM) calculates expected returns based on a security's systematic risk as measured by beta.

CFP Exam Tip: When a question asks about "non-diversifiable" or "market" risk, it is referring to systematic risk. Remember the key distinction: systematic risk is compensated (via market risk premium), while unsystematic risk is NOT compensated.

Types of Systematic Risk

1. Market Risk

Market risk is the risk that the overall market will decline, dragging down the prices of individual securities regardless of their fundamental quality. Even well-managed companies with strong financials will see their stock prices fall during a broad market decline.

Example: During the 2008 financial crisis and the 2020 COVID-19 market crash, virtually all stocks declined regardless of individual company performance. Even companies with no direct exposure to mortgages or the pandemic saw significant price drops.

2. Interest Rate Risk

Interest rate risk is the risk that changes in prevailing interest rates will negatively affect the value of investments. This risk primarily impacts fixed-income securities but also affects stocks, real estate, and other asset classes.

Key relationships:

• When interest rates rise, bond prices fall (inverse relationship)
• Longer-duration bonds have greater interest rate sensitivity
• Higher coupon bonds are less sensitive to interest rate changes than lower coupon bonds

Example: If you own a bond paying 3% and interest rates rise to 5%, your bond becomes less attractive to buyers. Its market price must fall until its yield becomes competitive with new bonds.

3. Inflation Risk (Purchasing Power Risk)

Inflation risk (also called purchasing power risk) is the risk that the return on an investment will not keep pace with inflation, resulting in a loss of real purchasing power.

Most vulnerable investments:

• Fixed-rate bonds with long maturities
• Cash and cash equivalents
• Fixed annuities

Example: A bond paying 3% annual interest may seem attractive, but if inflation is 4%, the investor is actually losing 1% in real purchasing power each year. Over 20 years, this erosion can be substantial.

4. Reinvestment Risk

Reinvestment risk is the risk that cash flows from an investment (interest, dividends, or maturing principal) will be reinvested at lower rates than the original investment.

Most affected by reinvestment risk:

• Callable bonds (issuer may call when rates fall)
• High-coupon bonds with significant cash flows to reinvest
• Certificates of deposit at maturity

Example: An investor holding a 5% bond faces reinvestment risk if rates fall to 3%. When the bond matures or pays coupons, those funds can only be reinvested at the lower 3% rate.

5. Exchange Rate Risk (Currency Risk)

Exchange rate risk is the risk that currency fluctuations will reduce the value of foreign investments when converted back to the investor's home currency.

Key points:

• Affects any investment denominated in a foreign currency
• American Depositary Receipts (ADRs) do NOT eliminate exchange rate risk
• Can work in the investor's favor if the foreign currency strengthens

Example: A U.S. investor buys European stocks worth €10,000 when €1 = $1.10. If the euro weakens to €1 = $1.00, the investment loses 9% of its dollar value even if the stock price remains unchanged.

6. Political Risk (Sovereign Risk)

Political risk is the risk that political instability, policy changes, or government actions will negatively impact investments. This includes changes in tax laws, trade policies, regulatory frameworks, or political upheaval.

Example: Changes in corporate tax rates, trade tariffs, or sanctions can significantly impact the profitability and stock prices of affected companies, even if their operations remain unchanged.

Summary: Types of Systematic Risk

The Beta Coefficient

Beta (β) is the primary measure of systematic risk. It quantifies how much a security's returns move relative to the overall market's returns. The market (typically represented by the S&P 500) has a beta of 1.0 by definition.

Interpreting Beta Values

Beta Examples

• Beta of 1.5: If the market rises 10%, this security is expected to rise 15%. If the market falls 10%, this security is expected to fall 15%.
• Beta of 0.75: If the market rises 10%, this security is expected to rise only 7.5%. It provides some downside protection in falling markets.
• Beta of -0.5: If the market rises 10%, this security is expected to fall 5%. Negative beta securities can serve as hedges.

Portfolio Beta

The beta of a portfolio is the weighted average of the individual security betas. This allows investors to adjust portfolio systematic risk by adding higher or lower beta securities.

Formula: Portfolio Beta = Σ (Weight × Individual Beta)

Example: A portfolio with 60% in Stock A (β = 1.2) and 40% in Stock B (β = 0.8): Portfolio Beta = (0.60 × 1.2) + (0.40 × 0.8) = 0.72 + 0.32 = 1.04

CFP Exam Tip: Beta is appropriate for measuring risk in a well-diversified portfolio because unsystematic risk has been diversified away. For a single security or non-diversified portfolio, standard deviation (total risk) is more appropriate.

Beta and CAPM

The Capital Asset Pricing Model (CAPM) uses beta to calculate the expected return on a security:

Expected Return = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate)

Or: r = rf + β(rm - rf)

Where:

• r = expected return on the security
• rf = risk-free rate (typically T-bill rate)
• β = beta of the security
• rm = expected return of the market
• (rm - rf) = market risk premium

Example: If the risk-free rate is 3%, the expected market return is 10%, and a stock has a beta of 1.5: Expected Return = 3% + 1.5(10% - 3%) = 3% + 1.5(7%) = 3% + 10.5% = 13.5%

Key Exam Points

What Makes Systematic Risk "Systematic"

1. Affects the entire market - Not specific to any company or industry
2. Cannot be diversified away - Adding more securities doesn't reduce this risk
3. Compensated risk - Investors receive the market risk premium for bearing it
4. Measured by beta - Beta quantifies sensitivity to market movements

Common Exam Scenarios

• Stock index funds and ETFs are subject to systematic risk (they track the market)
• A well-diversified portfolio has eliminated unsystematic risk, leaving only systematic risk
• When comparing investment performance, use beta-based measures (Treynor ratio) for diversified portfolios