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Chapter11: Risk and return

11.4 Risk: systematic and unsystematic

The unanticipated part of the return, that portion resulting from surprises, is the true risk of any investment. After all, if we always receive exactly what we expect, then the investment is perfectly predictable and, by definition, risk free. In other words, the risk of owning an asset comes from surprises—unanticipated events.

   There are important differences, though, among various sources of risk. Look back at our previous list of news stories. Some of these stories are directed specifically at Flyers, and some are more general. Which of the news items are of specific importance to Flyers?

   Announcements about interest rates or GDP are clearly important for nearly all companies, whereas the news about Flyers' president, its research or its sales solely relates to Flyers. We will distinguish between these two types of events because, as we shall see, they have very different implications.

SYSTEMATIC AND UNSYSTEMATIC RISK

The first type of surprise, the one that affects a large number of assets, we will label systematic riskA risk that influences a large number of assets.  Because systematic risks have market-wide effects, they are sometimes called market risks.

   The second type of surprise we will call unsystematic risk A risk that affects at most a small number of assets. Also unique or asset-specific risk. An unsystematic risk is one that affects a single asset or a small group of assets. Because such a risk is unique to an individual company or asset, it is sometimes called a unique or asset-specific risk. We will use these terms interchangeably.

   As we have seen, uncertainties about general economic conditions such as GDP, interest rates or inflation are examples of systematic risks. These conditions affect nearly all companies to some degree. An unanticipated increase, or surprise, in inflation, for example, affects wages and the costs of the supplies that companies buy; it affects the value of the assets that companies own; and it affects the prices at which companies sell their products. Forces such as these, to which all companies are susceptible, are the essence of systematic risk.

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   In contrast, the announcement of an oil strike by a company will primarily affect that company and, perhaps, a few others (such as primary competitors and suppliers). It is unlikely to have much of an effect on the world oil market, however, or on the affairs of companies not in the oil business, so this is an unsystematic event.

SYSTEMATIC AND UNSYSTEMATIC COMPONENTS OF RETURN

The distinction between a systematic risk and an unsystematic risk is never really as exact as we make it out to be. Even the most narrow and peculiar bit of news about a company ripples through the economy. This is true because every enterprise, no matter how tiny, is a part of the economy. It is like the tale of a kingdom that was lost because one horse lost a shoe. This is mostly hairsplitting, however. Some risks are clearly much more general than others. We shall see some evidence on this point in just a moment.

   The distinction between the types of risk allows us to break down the surprise portion, U, of the return on Flyers' shares into two parts. From before, we had the actual return broken down into its expected and surprise components:

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We now recognise that the total surprise for Flyers, U, has a systematic and an unsystematic component, so:

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Because it is traditional, we will use the Greek letter epsilon, ε, to stand for the unsystematic portion. Since systematic risks are often called market risks, we will use the letter m to stand for the systematic part of the surprise. With these symbols, we can rewrite the total return:

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   The important thing about the way we have broken down the total surprise, U, is that the unsystematic portion, ε, is more or less unique to Flyers. For this reason, it is unrelated to the unsystematic portion of return on most other assets. To see why this is important, we need to return to the subject of portfolio risk.

   

CONCEPT QUESTIONS

11.4a  

What are the two basic types of risk?

11.4b  

What is the distinction between the two types of risk?

     
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