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Subject 2. Systematic Risk and Unsystematic Risk PDF Download

Total risk is measured as the standard deviation of security returns. It has two components:

1. Systematic risk is the risk that is inherent in the market that cannot be diversified away. The systematic risk of an asset is the relevant risk for constructing portfolios. Examples of systematic risk or market risk include macroeconomic factors that affect everything (such as the growth in U.S. GNP, inflation, etc.).

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.

2. Unique, diversifiable, or unsystematic risk (or nonsystematic risk) is risk that can be diversified away. This risk is offset by the unique variability of the other assets in a portfolio. An investor should not expect to receive additional return for assuming unsystematic 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.

User Contributed Comments 6

User Comment
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
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I am using your study notes and I know of at least 5 other friends of mine who used it and passed the exam last Dec. Keep up your great work!
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