unsystematic risk
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In
finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of f ...
and
economics Economics () is the social science that studies the production, distribution, and consumption of goods and services. Economics focuses on the behaviour and interactions of economic agents and how economies work. Microeconomics anal ...
, systematic risk (in economics often called aggregate risk or undiversifiable risk) is vulnerability to events which affect aggregate outcomes such as broad market returns, total economy-wide resource holdings, or aggregate income. In many contexts, events like earthquakes, epidemics and major weather catastrophes pose aggregate risks that affect not only the distribution but also the total amount of resources. That is why it is also known as contingent risk, unplanned risk or risk events. If every possible outcome of a
stochastic Stochastic (, ) refers to the property of being well described by a random probability distribution. Although stochasticity and randomness are distinct in that the former refers to a modeling approach and the latter refers to phenomena themselv ...
economic process is characterized by the same aggregate result (but potentially different distributional outcomes), the process then has no aggregate risk.


Properties

Systematic or aggregate risk arises from market structure or dynamics which produce shocks or uncertainty faced by all agents in the market; such shocks could arise from government policy, international economic forces, or acts of nature. In contrast, specific risk (sometimes called residual risk, unsystematic risk, or idiosyncratic risk) is risk to which only specific agents or industries are vulnerable (and is uncorrelated with broad market returns). Due to the idiosyncratic nature of unsystematic risk, it can be reduced or eliminated through
diversification Diversification may refer to: Biology and agriculture * Genetic divergence, emergence of subpopulations that have accumulated independent genetic changes * Agricultural diversification involves the re-allocation of some of a farm's resources to n ...
; but since all market actors are vulnerable to systematic risk, it cannot be limited through diversification (but it may be insurable). As a result, assets whose returns are negatively correlated with broader market returns command higher prices than assets not possessing this property. In some cases, aggregate risk exists due to institutional or other constraints on market completeness. For countries or regions lacking access to broad hedging markets, events like earthquakes and adverse weather shocks can also act as costly aggregate risks.
Robert Shiller Robert James Shiller (born March 29, 1946) is an American economist, academic, and author. As of 2019, he serves as a Sterling Professor of Economics at Yale University and is a fellow at the Yale School of Management's International Center for ...
has found that, despite the
globalization Globalization, or globalisation (Commonwealth English; see spelling differences), is the process of interaction and integration among people, companies, and governments worldwide. The term ''globalization'' first appeared in the early 20t ...
progress of recent decades, country-level aggregate income risks are still significant and could potentially be reduced through the creation of better global hedging markets (thereby potentially becoming idiosyncratic, rather than aggregate, risks). Specifically, Shiller advocated for the creation of macro
futures markets A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts defined by the exchange. Futures contracts are derivatives contracts to buy or sell specific quantities of a commodity or ...
. The benefits of such a mechanism would depend on the degree to which macro conditions are correlated across countries.


In finance

Systematic risk plays an important role in portfolio allocation. Risk which cannot be eliminated through diversification commands returns in excess of the
risk-free rate The risk-free rate of return, usually shortened to the risk-free rate, is the rate of return of a hypothetical investment with scheduled payments over a fixed period of time that is assumed to meet all payment obligations. Since the risk-free ...
(while idiosyncratic risk does not command such returns since it can be diversified). Over the long run, a well-diversified portfolio provides returns which correspond with its exposure to systematic risk; investors face a trade-off between expected returns and systematic risk. Therefore, an investor's desired returns correspond with their desired exposure to systematic risk and corresponding asset selection. Investors can only reduce a portfolio's exposure to systematic risk by sacrificing expected returns. An important concept for evaluating an asset's exposure to systematic risk is
beta Beta (, ; uppercase , lowercase , or cursive ; grc, βῆτα, bē̂ta or ell, βήτα, víta) is the second letter of the Greek alphabet. In the system of Greek numerals, it has a value of 2. In Modern Greek, it represents the voiced labiod ...
. Since beta indicates the degree to which an asset's return is correlated with broader market outcomes, it is simply an indicator of an asset's vulnerability to systematic risk. Hence, the capital asset pricing model (CAPM) directly ties an asset's equilibrium price to its exposure to systematic risk.


A simple example

Consider an investor who purchases stock in many firms from most global industries. This investor is vulnerable to systematic risk but has diversified away the effects of idiosyncratic risks on his portfolio value; further reduction in risk would require him to acquire risk-free assets with lower returns (such as
U.S. Treasury securities United States Treasury securities, also called Treasuries or Treasurys, are government debt instruments issued by the United States Department of the Treasury to finance government spending as an alternative to taxation. Since 2012, U.S. go ...
). On the other hand, an investor who invests all of his money in one industry whose returns are typically uncorrelated with broad market outcomes (
beta Beta (, ; uppercase , lowercase , or cursive ; grc, βῆτα, bē̂ta or ell, βήτα, víta) is the second letter of the Greek alphabet. In the system of Greek numerals, it has a value of 2. In Modern Greek, it represents the voiced labiod ...
close to zero) has limited his exposure to systematic risk but, due to lack of diversification, is highly vulnerable to idiosyncratic risk.


In economics

Aggregate risk can be generated by a variety of sources.
Fiscal Fiscal usually refers to government finance. In this context, it may refer to: Economics * Fiscal policy, use of government expenditure to influence economic development * Fiscal policy debate * Fiscal adjustment, a reduction in the government ...
,
monetary Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are ...
, and
regulatory Regulation is the management of complex systems according to a set of rules and trends. In systems theory, these types of rules exist in various fields of biology and society, but the term has slightly different meanings according to context. ...
policy can all be sources of aggregate risk. In some cases, shocks from phenomena like weather and natural disaster can pose aggregate risks. Small economies can also be subject to aggregate risks generated by international conditions such as
terms of trade The terms of trade (TOT) is the relative price of exports in terms of imports and is defined as the ratio of export prices to import prices. It can be interpreted as the amount of import goods an economy can purchase per unit of export goods. An i ...
shocks. Aggregate risk has potentially large implications for economic growth. For example, in the presence of credit rationing, aggregate risk can cause bank failures and hinder capital accumulation. Banks may respond to increases in profitability-threatening aggregate risk by raising standards for quality and quantity
credit rationing Credit rationing is the limiting by lenders of the supply of additional credit to borrowers who demand funds at a set quoted rate by the financial institution. It is an example of market failure, as the price mechanism fails to bring about equil ...
to reduce monitoring costs; but the practice of lending to small numbers of borrowers reduces the diversification of bank portfolios (
concentration risk Concentration risk is a banking term describing the level of risk in a bank's portfolio arising from concentration to a single counterparty, sector or country. The risk arises from the observation that more concentrated portfolios are less div ...
) while also denying credit to some potentially productive firms or industries. As a result, capital accumulation and the overall productivity level of the economy can decline. In economic modeling, model outcomes depend heavily on the nature of risk. Modelers often incorporate aggregate risk through shocks to endowments (
budget constraint In economics, a budget constraint represents all the combinations of goods and services that a consumer may purchase given current prices within his or her given income. Consumer theory uses the concepts of a budget constraint and a preferenc ...
s),
productivity Productivity is the efficiency of production of goods or services expressed by some measure. Measurements of productivity are often expressed as a ratio of an aggregate output to a single input or an aggregate input used in a production proces ...
, monetary policy, or external factors like terms of trade. Idiosyncratic risks can be introduced through mechanisms like individual labor productivity shocks; if agents possess the ability to trade assets and lack borrowing constraints, the welfare effects of idiosyncratic risks are minor. The welfare costs of aggregate risk, though, can be significant. Under some conditions, aggregate risk can arise from the aggregation of micro shocks to individual agents. This can be the case in models with many agents and
strategic complementarities In economics and game theory, the decisions of two or more players are called strategic complements if they mutually reinforce one another, and they are called strategic substitutes if they mutually offset one another. These terms were originally ...
; situations with such characteristics include: innovation, search and trading, production in the presence of input complementarities, and information sharing. Such situations can generate aggregate data which are empirically indistinguishable from a data-generating process with aggregate shocks.


Example: Arrow–Debreu equilibrium

The following example is from Mas-Colell, Whinston, and Green (1995). Consider a simple exchange economy with two identical agents, one (divisible) good, and two potential states of the world (which occur with some probability). Each agent has expected utility in the form \pi_1*u_i(x_)+\pi_2*u_i(x_) where \pi_1 and \pi_2 are the probabilities of states 1 and 2 occurring, respectively. In state 1, agent 1 is endowed with one unit of the good while agent 2 is endowed with nothing. In state 2, agent 2 is endowed with one unit of the good while agent 1 is endowed with nothing. That is, denoting the vector of endowments in state ''i'' as \omega_i, we have \omega_1=(1,0), \omega_2=(0,1). Then the aggregate endowment of this economy is one good regardless of which state is realized; that is, the economy has no aggregate risk. It can be shown that, if agents are allowed to make trades, the ratio of the price of a claim on the good in state 1 to the price of a claim on the good in state 2 is equal to the ratios of their respective probabilities of occurrence (and, hence, the marginal rates of substitution of each agent are also equal to this ratio). That is, p_1/p_2=\pi_1/\pi_2. If allowed to do so, agents make trades such that their consumption is equal in either state of the world. Now consider an example with aggregate risk. The economy is the same as that described above except for endowments: in state 1, agent 1 is endowed two units of the good while agent 2 still receives zero units; and in state 2, agent 2 still receives one unit of the good while agent 1 receives nothing. That is, \omega_1=(2,0), \omega_2=(0,1). Now, if state 1 is realized, the aggregate endowment is 2 units; but if state 2 is realized, the aggregate endowment is only 1 unit; this economy is subject to aggregate risk. Agents cannot fully insure and guarantee the same consumption in either state. It can be shown that, in this case, the price ratio will be less than the ratio of probabilities of the two states: p_1/p_2<\pi_1/\pi_2, so p_1/\pi_1. Thus, for example, if the two states occur with equal probabilities, then p_1. This is the well-known finance result that the contingent claim that delivers more resources in the state of low market returns has a higher price.


In heterogeneous agent models

While the inclusion of aggregate risk is common in
macroeconomic model A macroeconomic model is an analytical tool designed to describe the operation of the problems of economy of a country or a region. These models are usually designed to examine the comparative statics and dynamics of aggregate quantities such a ...
s, considerable challenges arise when researchers attempt to incorporate aggregate uncertainty into models with
heterogeneous agents In economic theory and econometrics, the term heterogeneity refers to differences across the units being studied. For example, a macroeconomic model in which consumers are assumed to differ from one another is said to have heterogeneous agents. ...
. In this case, the entire distribution of allocational outcomes is a
state variable A state variable is one of the set of variables that are used to describe the mathematical "state" of a dynamical system. Intuitively, the state of a system describes enough about the system to determine its future behaviour in the absence of a ...
which must be carried across periods. This gives rise to the well-known
curse of dimensionality The curse of dimensionality refers to various phenomena that arise when analyzing and organizing data in high-dimensional spaces that do not occur in low-dimensional settings such as the three-dimensional physical space of everyday experience. T ...
. One approach to the dilemma is to let agents ignore attributes of the aggregate distribution, justifying this assumption by referring to
bounded rationality Bounded rationality is the idea that rationality is limited when individuals make decisions, and under these limitations, rational individuals will select a decision that is satisfactory rather than optimal. Limitations include the difficulty o ...
. Den Haan (2010) evaluates several algorithms which have been applied to solving the Krusell and Smith (1998) model, showing that solution accuracy can depend heavily on solution method. Researchers should carefully consider the results of accuracy tests while choosing solution methods and pay particular attention to grid selection.


In projects

Systematic risk exists in projects and is called the overall project risk bred by the combined effect of uncertainty in external environmental factors such as
PESTLE Mortar and pestle is a set of two simple tools used from the Stone Age to the present day to prepare ingredients or substances by crushing and grinding them into a fine paste or powder in the kitchen, laboratory, and pharmacy. The ''mortar'' () ...
, VUCA, etc. It is also called contingent or unplanned risk or simply uncertainty because it is of unknown likelihood and unknown impact. In contrast, systemic risk is known as the individual project risk, caused by internal factors or attributes of the project system or culture. This is also known as inherent, planned, event or condition risk caused by known unknowns such as variability or ambiguity of impact but 100% probability of occurrence. Both systemic and systematic risks are residual risk.


See also

*
Modern portfolio theory Modern portfolio theory (MPT), or mean-variance analysis, is a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk. It is a formalization and extension of diversificati ...
*
Capital asset pricing model In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio. The model takes into ac ...
*
Risk modeling Financial risk modeling is the use of formal mathematical and econometric techniques to measure, monitor and control the market risk, credit risk, and operational risk on a firm's balance sheet, on a bank's trading book, or re a fund manager's ...
*
Taleb distribution In economics and finance, a Taleb distribution is the statistical profile of an investment which normally provides a payoff of small positive returns, while carrying a small but significant risk of catastrophic losses. The term was coined by j ...


References

{{DEFAULTSORT:Systematic Risk Financial markets Financial risk Economic systems