Systematic and Unsystematic Risks - Assignment Example

Running Header: systematic and unsystematic risks Student’s Name: Instructor’s Name: Course Code & Name: Date of Submission: Table of Contents 2 Table of Contents 2 1.0 Introduction 3 2.0 Systematic and unsystematic Risks 3 3.0 Methods of analyzing systematic and Unsystematic Risk 4 3.1Beta Analysis 4 3.11 Covariance Method 4 3.12 Regression method 4 3.13 Disadvantages of Beta Analysis 5 3.2 Capital Asset Pricing Model 5 3.3 Securities Market Line 6 4.0 Managing Systematic and Unsystematic Risks 6 4.1 Asset allocation 7 4.2 Diversification 7 4.3 Beta analysis 8 5.0 How systematic and unsystematic risks affect share prices 9 Conclusions 9 References 10 1.0 Introduction Risk in finance occurs when investors are faced with uncertainty in relation to the returns of their investments. An investor must ensure that a balance exists between the risk and returns in order to avoid financial loss. Maheshwari (2008) notes that all investors desire to maximize their returns while at the same time they aim at minimizing the risks that are associated with their investments. Investor must identify the appropriate techniques to utilize so as to manage the risks associated with their investments. The fact that some investments are more risky than others require the investors to measure the risk associated with their investments in order to determine the minimum expected returns. Moreover, the investors must come up with methods of minimizing their risks. Therefore, this paper is going to identify the methods used by investors to analyze and manage systematic and unsystematic risks. In addition, the paper will show how systematic and unsystematic risks affect share prices. 2.0 Systematic and unsystematic Risks According to Moyer, McGuigan and Kretlow (2008) systematic risk refers to that risk that cannot be diversified. Systematic risk occurs due to the variability of a portion of a security returns and this is caused by factors that affect the market as a whole and thus the risk is non-diversifiable. The factors include changes in interest rates, changes in the performance of the economy and changes in the purchasing power as a result of inflation. On the other hand, unsystematic risk refers to that risk that the investor can reduce through diversification. Unsystematic risk can be caused by factors like strikes, management competencies, and competition. 3.0 Methods of analyzing systematic and Unsystematic Risk Systematic risk is of high importance to an investor because it cannot be reduced through diversification (Periasamy, 2009). Investors in the share markets measure the systematic risk before they make their investment decisions. 3.1Beta Analysis Puxty and Dodds (1998) note that systematic risk of a security can be measured statiscally by the use of Beta which analyses the volatility of a stock. Beta is used to measure how the price of a stock responds to price movements in the market. Through the use of beta investor in the share markets are able to determine how the systematic risk of a stock is correlated with the price changes in the stock market as a whole (Periasamy, 2009). The beta explains how the returns on a market portfolio investment are correlated to a given stock. Sheeba (2009) states that beta can be calculated using the covariance method or the regression method. 3.11 Covariance Method The risk of the stock can be measured by the use of standard deviation which measures the covariance of the stock as compared with that of the market. In this case, the beta of a stock is calculated using historical data whereby the returns of the stock as well as those in the stock market index are used. Using this method, the beta of the stock is represented by the covariance between the returns of the given stock and that of the market index. 3.12 Regression method The regression method measures the changes that occur in the dependent variable as a result of a unit change in the independent variable. To calculate beta, the return of the given stock is taken to be the dependent variable while the return of the market index is taken to represent the independent variable (Kevin, 2006). The Beta of the market is taken to be 1.0 because of the fact that it has unit sensitivity to its return. Therefore, the volatility of the systematic risk in relation to the given stock can either be expressed as either negative, positive or zero. A stock with a beta that is greater than 1or positive means that it is more sensitive to the changes in the market. This means that the stock has a higher systematic risk than the market stocks. When the beta of a stock is less than 1 or negative, it implies that the stock is less sensitive to the variations in the market stocks. Stock with beta equal to 1 means that the risk of the stock is equal to that of the market as a whole (Periasamy, 2009). This implies that the sensitivity of the stock is equal to that of the market. 3.13 Disadvantages of Beta Analysis Periasamy (2009) notes that beta does not explain the relationship that exists between the stock and the general market. The changes in the stock and the general market are dependent on the economy which in turn causes the changes in the systematic risk. Moreover, better is calculated on historical data which may not accurately reflect the changes that might occur in the future in relation to the prices of the shares. Furthermore, it is difficult to accurately measure the level of systematic risk associated with an individual risk hence the method may not be appropriate to use in measuring systematic risk of a stock. 3.2 Capital Asset Pricing Model According to Madura (2012) capital asset pricing model (CAPM) is based on the principle that only systematic risk is important as it is determined by general movements in the prices of stocks in the market. The method utilizes beta in order to determine the systematic risk of a given stock. The CAPM states that the returns of a stock is determined by the existing risk free rate, the beta of the stock and the return of the market. CAPM assumes that investors are risk averse and they will require additional returns for undertaking additional risks. Myrtle, Clark and Cathey (2010) argue that investors using CAPM as the basis for analyzing their portfolios will only be subject to systematic risk. Therefore, the investors will be able to identify the systematic risk given that it’s the only factor that determines their returns. The expected rates of return estimated by using CAPM will differ between different stocks due to the differences in their systematic risks. Given the expected return, it is thus possible to calculate and analyze the systematic risk. 3.3 Securities Market Line The securities market line (SML) defines risk as systematic risk and it is calculated by beta (Kevin, 2006). This method can be applied to those stocks whose total risk is equal to the systematic risk. The systematic risk and the total risk are equal to for only the efficient stocks because their risks cannot be diversified. Therefore, the SML will show the systematic risk return trade off for all the individual stocks. 4.0 Managing Systematic and Unsystematic Risks According to Maheswari (2008) systematic risk can be managed by the use of beta while unsystematic risk can be minimized through portfolio management. Managing a portfolio involves selecting, maintaining and continuously evaluating the performance of the portfolio. Investors can select their stock portfolios based on their perceptions towards the risks and returns of an individual share. A portfolio can be managed through asset allocation and diversification 4.1 Asset allocation Parker (2011) argues that asset allocation aims at determining the most suitable markets which can offer an investor sufficient returns. The market should outperform the other markets in relation to its returns in order to warrant the investors to invest their funds in shares that belong to that market. Asset allocation takes into consideration the risk and returns of diverse investments in different locations and combines them into a portfolio so as to achieve either the least risk as compared to the investment returns or the maximum returns relative to the risk linked with the investment. To identify the efficient share portfolios to invest in and reduce the unsystematic risk, the investor can use either the special based techniques or style based methods. The special based techniques include geographic strategies, sector strategies and economic based strategies. Sector strategies present the investors with an opportunity to identify the best market sector to invest their shares in. The geographic strategies involve the investors indentifying the most suitable geographic location to invest their share. On the other hand, style based methods include opportunistic approaches, core portfolios and value added approaches. 4.2 Diversification Unsystematic risk can be further reduced through diversification (Babu, 2007). It involves combining different securities in order to form a portfolio. Through diversification the investors expand their existing portfolios or change the combination of their portfolios without buying additional shares. The investors reduce the systematic risk by buying shares from many different companies and industries. Moreover, the investors make sure that they purchase the right number of the shares in the portfolio without exposing themselves to excessive risks. In this case the investors aim at maximizing their returns while at the same time they seek to reduce the risk associated with their shares. Pariasamy (2009) notes that diversification assists to maximize the returns pertaining to a given level of risk in a portfolio. In this case the investors either diversify their returns by purchasing shares of different companies or shares in different industry lines. The policy of diversification holds that investors should not put all their ‘eggs in one basket’. The methods of diversification used by investors in the share market include the random selection method, the optimum selection method and the adequate diversification method. In the random selection the investors select companies to invest in randomly while in optimum selection method the investors select as many companies as possible where they intend to invest their money. On the other hand, investors utilize the adequate selection method by selecting an adequate number of companies to invest in. In this case, the investors hold the belief that maintaining an adequate number of industries and companies in a portfolio minimizes their risks. 4.3 Beta analysis Systematic risk acts as the most important risk to an investor because it cannot be eliminated through diversification (Pariasamy, 2009). Investors in the stock market utilize beta in order to measure the risk of a given investment. According to Keown at el (2003) the investors begin by estimating the systematic risk of a given firm using historical accounting data. The investors then identify a substitute firm in the same industry where they want to invest their funds and estimate its systematic risk using the data collected earlier as a benchmark. 5.0 How systematic and unsystematic risks affect share prices A study conducted by Kouvelis at el (2011) found out that systematic and unsystematic risks were critical factors used by investors in order to value the stocks of a firm. Systematic and unsystematic risks affects the returns that the investors demand for holding the firm’s shares and this has a direct affect on the firms share prices. In addition, the higher the systematic and the unsystematic risks the higher is the cost of the firm’s equity capital. This means that increased systematic and unsystematic risks can make firms shares to be less attractive to invest in and this will consequently reduce the value of the shares. Moreover, investors will be unwilling to invest in volatile shares and this will lead to a reduction in price of such shares. An increase in systematic and unsystematic risk will lead to an increase in the required rate of return and this will in turn lead to a decrease in the firms share prices (Khan and Jain, 2007). Reducing the systematic and unsystematic risks leads to an increase in value of a company’s shares and this leads to an increase in the price of the shares. Conclusions To conclude, systematic risk refers to that risk that cannot be minimized through diversification while unsystematic risk refers to that risk that can be minimized through diversification. Systematic risk can be analyzed used beta, Capital asset pricing model and the securities market line. An investor can minimize systematic risk by measuring the beta of the individual stock in order to determine its volatility as compared to that of the market. On the other hand, unsystematic risk can be minimized through asset allocation and diversification. Finally an increase in the systematic and unsystematic risk leads to an increase in the required rate of return hence this reduces the price of the given stock. References Babu, R. (2007). Portfolio Management. New Delhi, Ashok Kumar Mittal. Kevin, S. (2006). Security Analysis and Portfolio Management. New Delhi, Prentice-Hall. Keown, A., Martin, J., Petty, J & Scott, D. (2003). Foundations of Finance. New Delhi, Prentice- Hall. Khan, M., & Jain, P. (2007). Financial Management. New Delhi, Tata McGraw –Hill. Kouvelis, P., Dong, L., Boyabatli., O & Li, R. (2011). Handbook of Risk Management. West Sussex, John Wiley & Sons. Madura, J. (2012). Financial Markets and Institutions. Mason, South-Western Cengage Learning. Maheshwari, Y. (2008). Investment Management. New Delhi, Rajkamal Electric Press. Moyer, R., Mcguigan, J., & Kretlow, W. (2008) Contemporary Financial Management. Mason, South-Western Cengage Learning. Parker, D.(2011). Global Real Estate Investments and Trusts. West Sussex, John Wiley & Sons. Periasamy, P. (2009). Financial Management. New Delhi, Tata McGraw-Hill. Puxty, A., & Dodds, J. (1998). Financial Management. Chichester, Van Nostrand Reinhold Co. Ltd. Schroeder, R., Clark. M& Cathey, J. (2010). Financial Accounting Theory and Analysis. West Sussex, John Wiley & Sons. Sheeba, K. (2009). Financial Management. New Delhi, Dorling Kindersley. Read More