Differences between Systematic, Unsystematic and Total Risks - Assignment Example

Meaning of Systematic, Unsystematic and Total Risk: Risk refers to variations in earnings and includes the chance you may lose money on an investment. Systematic Risk: Systematic risk is the risk associated with aggregate market returns. As the market moves, each individual asset is affected. To the extent that any asset participates in such general market moves, that asset entails systematic risk. Systematic risks often originate from political or economical problems, wars, interest rate changes, and calamities and they are usually hard to avoid. They necessitate change of plans and strategies by governments, companies, banks and financial markets. For instance, a general recession in the economy would have adverse effect on all the securities in the market. Systematic risk is risk which applies to whole market or market segment and affects virtually all the securities. Therefore, it is not possible to eliminate systematic risk through diversification. Diversification involves spreading the investments over a range of investment instruments to minimize the risk of losing all the assets should one investment go bad. However, systematic risk is caused by factors that affect the prices of virtually all securities, but in different proportions. Due to this, it is possible to reduce systematic risk by acquiring securities that have histories of relatively slowly changing prices. For instance, in a diversified portfolio containing stocks, bonds, real estate and savings accounts, the values of the investments do not all increase or decrease at the same time or in the same magnitude, and one can therefore protect oneself against fluctuations. Alternatively, an investor may diversify into different lines of business that are not subject to the same economic and political influences and thus protect investments against fluctuations in earnings. The other names by which systematic risk is known are Market risk, Aggregate risk and Non diversifiable risk. Measurement: Systematic risk is measured in terms of Beta (β). Beta of an asset measures the sensitivity of the asset with respect to a broad based market index. For example, if a company’s beta is 2.0 and the stock market goes up 10 percent, the company’s common stock goes up 20 percent. It is measured as follows: Beta of an asset (β) = Change in rate of return of asset / Change in market rate of return OR βi = Cov(Ri, Rm) / Var(Rm) Where, Cov(Ri, Rm) : Covariance between rate of return of the asset and market rate of return Var(Rm) : Variance of market rate of return OR βi = Cor(Ri, Rm)2 x SDi2 Cor(Ri, Rm) = Correlation co-efficient between rate of return of the asset and market rate of return SDi = Standard Deviation of rate of return of asset Beta of a portfolio (βp) = Weighted Average betas of all securities in the portfolio Interpreting Beta: Beta What it Means 0 The security’s return is independent of the market. An example is a risk free security such as a T-bill 0.5 The security is only half as responsive as the market. 1.0 The security has the same responsiveness or risk as the market. This is the beta value of the market portfolio. 2.0 The security is twice as responsive, or risky as the market. (Jae K.Shim & Joel G. Siegel, c 2000, p. 124) Unsystematic Risk: Unsystematic risk, also called Diversifiable risk, is the risk arising due to circumstances unique to specific security, as opposed to the overall market. It is the risk that is specific to an industry or firm. For instance, a strike going on in a company would expose that particular company to unsystematic risk. Other examples of unsystematic risk include losses caused by labor problems, nationalization of assets, weather conditions or weak management. Unlike systematic risk, unsystematic risk is not common to all the securities in the market. Therefore, this type of risk can be reduced by assembling a portfolio with significant diversification as compared to the risk involved in holding an individual asset. A simple example will help make this point clear. Suppose you are offered the chance to flip a coin once; if a head comes up, you win $20,000, but if it comes up tails, you lose $16,000. This is a good bet – the expected return is $2,000 [0.5(20,000) + 0.5(-16,000)]. However, it is a highly risky proposition because you have a fifty percent chance of losing $16,000. Thus, you might well refuse to make the bet. Alternatively, suppose you were offered the chance to flip a coin 100 times, and you would win $200 for each head but lose $160 for each tail. It is possible that you would flip all heads and win $20,000, and it is also possible that you would flip all tails and lose $16,000, but the chances are very high that you would actually flip about 50 heads and about 50 tails, winning a net of about $2,000. Although each individual flip is a risky bet, collectively you have a low-risk proposition, because most of the risk has been diversified away. The concept of diversification can be further explained with a numerical example. Supposing an investor is considering the following investments with respective unsystematic risks: Investments Risk A 0.30 B 1.20 C 0.75 D 1.95 E 1.80 F 0.20 Govt Bond 0.00 The investor may want to invest in securities B, D and E expecting higher returns from it. However, in order to reduce portfolio risk, the investor should diversify and invest in securities having lower risks. In this way, the investor will be able to reduce the unsystematic risks in investments through diversification. Measurement: Unsystematic Risk = [1 – Cor (Ri, Rm)2] x SDm2 Where, Cor(Ri, Rm) = Correlation co-efficient between rate of return of the asset and market rate of return SDi = Standard Deviation of rate of return of asset Total Risk: Total risk is the sum of Systematic Risk and Unsystematic risk. Mathematically, Total Risk = Systematic Risk + Unsystematic Risk Portfolio risk can be graphically presented as follows: ` (Weston J, Besley S & Brigham F, c 1996, p. 200) Investment decisions considering the total risk can be made as follows: Investment decisions here are made based on the severity of risk involved as well as the probability of its occurrence. Risk Index Magnitude and Acceptability > 20 Maximum: Unacceptable – Maximum disruption of project plan, maximum threat to project success, implement new process or change baseline plan 15 to 20 High: Unacceptable – Slightly high disruption of project plan, slightly high threat to project success 10 to 15 Medium: Acceptable – Some disruption of project plan, some threat to project success, aggressively manage, consider alternative processes 5 to 10 Low: Acceptable – Little disruption of project plan, little threat to project success, some management actions necessary < 5 Minimum: Acceptable – No disruption of project, no threat to project success, current approach is sufficient Continuing the abovementioned example under unsystematic risk, Security Unsystematic Risk Systematic Risk Total Risk A 0.30 0.40 0.70 B 1.20 0.50 1.70 C 0.75 0.35 1.10 D 1.95 0.65 2.60 E 1.80 0.58 2.38 F 0.20 0.60 0.80 Govt. Bond 0.00 0.00 0.00 If the investor considers only unsystematic risk, excluding the risk free government bond, Security F would be considered as the investment with lowest risk. However, if systematic risk alone is considered, Security C would be considered as the one with lowest risk. But, the decision should be based on the total risk involved which shows that Security A has the lowest total risk. Therefore, investments based on total risk would be appropriate. Director’s Comments: “If we hold a portfolio of stocks we need only consider the systematic risk of the securities” Systematic risk is the risk associated with market returns. It affects all the securities in the market. However, every security also gets affected by unsystematic risk that is inherent to that security. Therefore, it would be necessary to consider both, systematic risk as well as unsystematic risk while considering the risks that affect a portfolio. But the fact to be borne in mind is that unsystematic risk can be eliminated through diversification whereas systematic risk cannot be eliminated in the same manner. This distinction makes systematic (non-diversifiable) risk the relevant risk as it reflects a security’s contribution to the risk of a portfolio. The statement made by the first director that only the systematic risk of the securities in a portfolio needs to be considered is valid to the extent that the unsystematic risk should be considered only for making decisions regarding diversification. But, it is the systematic risk which cannot be eliminated that would mainly cause a concern to the company. “As a cautious investor we must always consider total risk” A cautious investor would always prefer to invest in assets that are not subject to high risks. At the same time, the investor would expect to attain maximum possible returns at minimum risk. Irrespective of how cautious the investor is, one cannot avoid systematic risk. Unlike unsystematic risk, systematic risk cannot be eliminated through diversification. Therefore, out of the total risk, only the systematic risk would be relevant. The statement made by the second director that a cautious investor must always consider total risk does not hold good because it is only the systematic risk that would make a significant impact on the portfolio held by the investor. The investor can eliminate unsystematic risk through diversification and hence should consider the systematic risk portion of the total risk. “We should not buy anything if the expected return is less than the market as a whole and certainly not if it is below the return on the risk free asset” ‘Higher the risk, higher the return’ is a common rule. What this means is that an investor would expect a risk premium for any risk taken by making an investment choice. For instance, if an unknown company issues shares, an investor would consider it much more risky to invest in that company’s shares as compared to investing in government securities. If the government security as well as the company is earning the investor same rate of return, the investor would rather invest in government securities that is a risk free investment than investing in the company’s share that is risky. In order to induce the investor to invest in the company’s shares, the company would have to provide the investor with a return that is higher than the return given by the government security. If the rate of return expected from a particular investment is lower than that of the market, it would mean that there are other options of investment in the market that would provide higher returns. It would not be advisable for the investor to invest in a security that gives such lower returns. The investor should opt for the investments in the market that give better returns for the same risk. Therefore, the director’s statement is valid. Answer to question 2: (a) Importance of discounting future cash flows: Discounted cash flow (DCF) is what someone is willing to pay today in order to receive the anticipated cash flow in future years. In other words, discounting involves the process of finding the present value of a cash flow or a series of cash flows. Through DCF approach, one can value a company, project or asset based on the cash flows expected from such company, project or asset. All future cash flows are estimated and discounted at opportunity cost of capital or expected rate of return to give their present values. Opportunity cost of capital rate is the rate of return on the best available alternative investment of equal risk. Cash flows are discounted to reflect two aspects: (1) Time Value of Money and (2) Risk Premium Value of money does not remain same always. A dollar in hand today is worth more than a dollar to be received in the future because, if you had it now, you could invest it, earn interest, and end up with more than one dollar in the future. Also, the amount of money that buys you something today may not buy you the same thing in the future. For instance, if a pen could be purchased with $1 today, same pen may cost $2 in the future. Investors would rather have cash immediately than having to wait and must therefore be compensated by paying for the delay. The time value of money represents the interest one might earn on a payment received today, if held, earning interest, until that future date. Estimated future cash flows always involve an element of risk. Risk premium reflects the extra return investors demand because they want to be compensated for the risk that the cash flow might not materialize. A risk premium is the minimum difference a person requires to be willing to take an uncertain bet, between the expected value of the bet and the certain value that he is indifferent to. In finance, the risk premium can be the expected rate of return above the risk-free interest rate. For instance, if a government bond is issued at a risk free interest rate of 5%, a private bond would be required to be issued at an interest rate higher than the risk free rate of interest of 5% to induce investors to invest in such a bond. If such bond is issued carrying 8% interest rate, 3% (8%-5%) would be the risk premium provided for the risk taken by the investor by investing in a private bond instead of the risk free government bond. Therefore, a cash flow should be discounted to give effect to the time value of money and risk involved in the estimated future cash flow. < http://www.valuebasedmanagement.net/methods_dcf.html> (b) Computation of Net Present Value (NPV): Net Present Value = Present value of Cash Inflow – Present value of Cash Outflow Year Yearend Cash Flow (£) Present Value Factor (@12%)* Present Value of Cash Flow (£) 0 (100,000) 0.000 (100,000) 1 10,000 0.893 8,930 2 20,000 0.797 15,940 3 40,000 0.712 28,480 4 50,000 0.636 31,800 5 30,000 0.567 17,010 NPV 2,160 *Present Value Factor = 1/(1+i)n Where, i: Opportunity cost of capital & n: Year in which CF earned Since the Net Present Value of the investment is positive (2160), it indicates that the present value of the cash inflows from the investment exceeds cash outflow required. Therefore, it would be advisable for Susie Lee to make this investment. However, it should be borne in mind that the conclusion arrived at based on NPV is not free from uncertainties regarding the expected cash flow and cost of capital rate. Bibliography Jae K.Shim & Joel G. Siegel, c 2000, Financial Management, 2nd Edn, Barron’s Business Library, New York C. Preyssl & R. Atkins, T. Deak, Risk Management at ESA, viewed 29th March, 2009, Fred Weston J, Scott Besley & Eugene Brigham F, c 1996, Essentials of Managerial Finance, 11th Edn, The Dryden Press, Florida Discounted Cash Flow – DCF, viewed 29th March, 2009, Read More