Systematic Risk and Unsystematic Risk
Total risk is measured as the standard deviation of security returns. It has two components:
Note that different securities may respond differently to market changes, and thus may have different systematic risks. For example, automobile manufacturers are much more sensitive to market changes than discount retailers (e.g., Wal-Mart). As a result, automobile manufacturers have higher systematic risk.
Systematic risk is priced, and investors are compensated for holding assets or portfolios based only on that investment's systematic risk. Investors do not receive any return for accepting unsystematic risk.
A return-generating model tries to estimate the expected return of a security based on certain parameters. Both the market model and CAPM are single-factor models. The common, single factor is the return on the market portfolio. Multifactor models describe the return on an asset in terms of the risk of the asset with respect to a set of factors. Such models generally include systematic factors, which explain the average returns of a large number of risky assets. Such factors represent priced risk, risk which investors require an additional return for bearing.
According to the type of factors used, there are three categories of multifactor models:
Here is a two-factor macroeconomic model.
The model says stock returns are explained by surprises in GDP growth and interest rates. The regression analysis is usually used to estimate assets' sensitivities to these factors.
Calculation and Interpretation of Beta
Beta (β) is the standardized measure of systematic risk.
Since all investors want to hold the market portfolio, a security's covariance with the market portfolio (Covi,M) is the appropriate risk measure. Covi,M is an absolute measure of the security's systematic risk. Its magnitude is affected by the variability of both the security and the market portfolio (recall that Covi,j = pi,j x σi,j x σi,j). To standardize the measure of systematic risk, divide Covi,M by the covariance of the market portfolio with itself (CovM,M). Therefore, the standardized measure of systematic risk (beta) is defined as β = Covi,M / CovM,M = Covi,M / σM2 = ρi,M σi/σM.
|GeorgeC: unsystematic risk is also called idiosyncratic risk (remember you'd have to be an idiot to have idiosyncratic risk in your portfolio!!).|
| jgraham6: "Investors can reduce systematic risk by diversifying globally rather than in the U.S. only."|
Is this still true?
|scancubus: If you are a professor, yes.|
|dmfcrowe: Yep, all nice little theories on paper, in practical terms not particularly usefull. All based on past performance for a start, and almost completely unworkable in real life. Try working out the the covariances and correlations in a 50 security portfolio each time its changed. Efficient frontier? I think not.|
|johntan1979: Well, well... quite obviously, we still have living specimens of primitive humans, because it has been estimated that the value of non-U.S. assets exceeds 60% of the world total. Furthermore, U.S. equities make up only about 10% of total world assets.|
|RamaG: the key is to find the asset classes that will be -very correlated in the near future.. Adding T bills (kindda risk free) , Gold during 2008-12 period and then adding Japan stocks between 3rd quarter 2012 - 2nd quarter 2013 are sound examples of implementation of this sound theory in real world.. Of course the theory will not tell you what the ideal asset classes are going to be|