The Difference between Systematic and Specific Risk - Example

Systematic Risk and Specific Risk Systematic Risk Overview Scholars lack a consensus on the definition of systematic risk. However, most of them concur that it addresses matters surrounding the principles of avoiding financial instability. For this discourse, a systematic risk is a type of danger that an event will result into loss of confidence in a considerable portion of the financial system adequate to have serious effects for the real economy (Chingos, 2002, p. 67). The Financial Stability Oversight Council holds of the systematic risk that as much as there is no unified means of defining a systematic risk, most of the definitions aim at capturing the stability of the financial system as a whole. This is as opposed to the risk that individual financial organizations face as well as market participants. The systematic risk puts together all likely sources of instability within the financial system. It covers much more than failures in a single firm big enough. The systematic risk may lead to increased public policy concerns since it does not occur in the interest of specific financial organizations to consider the full likelihood of costs of the risks due its actions. It is not easy to insure against all types of systematic risks. This is because they have many sources of insurance therefore, hedging will expose the institution to damage in case of similar scenes exposing the system to greater loses. Sources of Systematic Risks Theory provides that an individual person, a single firm, financial utility, government, policy, or market carry the potential to cause financial instability. Other sources appear to the financial institutions via indirect channels, which include radical changes affecting market prices for all participants in the market, or factors that create panic concerning the financial status of similar institutions. The capacity of a single entity to pose systematic risk comes from the ability to create contracts and relationships with others magnifying and spreading upsets within the financial system. Accountants apply the terminology domino effect during occasions when interconnectedness leads to failure of one entity to result in the failure of part of counterparts and creditors (Myers, 2009, p. 29). In the event that almost three, billion cause a company to fail in its pledge of fulfilling commitments to other companies, then failure of one of the firm’s direct counterparts will would demonstrate a domino effect. Losses experienced by JP Morgan recently illustrate this case effectively. The company capital is a source that avoids failing by absorbing losses. In the same breadth, the financial market for JP Morgan counterparties contains capital insulation of their own to absorb losses and in the process avoid failing. In this case, losses must exceed capital insulation to spread through the domino effect channel. Poor image created by bad news about a financial institution sounds an alarm once the investors fear that other organizations might have similar damaged liabilities and assets even if the financial institution does not fail. Experts in financial matters apply the term contagion when possible creditors and investors avoid entities appearing to have characteristics of failure (Milkovich, Newman, & Gerhart, 2014, p. 112). If information regarding losses at JP Morgan could generate fears and features similar to the risky activities engaged by Citigroup or Bank of America independently, definitely contagion could impair inter-bank lending rates. Real losses need not exceed capital insulations to spread the systematic risk in the entire contagion channel because of the functions of panic and uncertainty. A clearinghouse and settlement systems are examples of financial utilities that result in systematic risks once their failures minimize the basic source for important financial services. It is in this aspect that accountants use the terminology critical function. The term applies during circumstances when a financial institution leads to the loss of a significant financial service without close substitutes. Using JP Morgan as an example in this case, the company offers various clearing functions and settlement for complicated financial markets including the market that runs the business of buying and selling of agreements. The large market share controlled by JP Morgan results into worries regarding the failure of the company spreading systematic risk in the entire essential function system although, other companies exist in the market that provide the same services. A market is also another source of systematic risk. This takes place when it sends a price signal to all participants in the market enhances characteristics that increase the occurrence of losses under some situations. One of the examples in this source is the collaterized debt. The terminology defines the process of borrowing to build an investment as well as using the same investment as a security to secure a loan. The mortgage presents the house as a security for the loan. Economists and other scholars posit that a decline in market prices directly leads to borrowers defaulting. This is despite the fact that when lenders take advantage of the situation of taking the collateral to shield their losses, they provide more of the new investment better for sale defying the decline in prices (Jensen, & Meckling, 2006, p. 315). Economists use the term fire sale when conditions compel a person to provide something for sale at a lower price in situations considered temporarily depressed market conditions as opposed to what the product would fetch under normal market conditions. An illustration of a market prone to self-reinforcing fire sales is the collaterized debt. The same reasons explain why the market remains prone to price bubbles. If a policy enhances the chances of a systematic event occurring, then it carries the ability to cause a systematic risk. Cliques of scholars posit that a standard policy that facilitates a mark-to-market accounting increases the systematic risk by encouraging the probability of fire sales. In this scenario, companies mark the value of an asset at the going price as opposed to reporting the assets in their records using the historic cost. However, opponents of this assertion hold that a decline in asset prices results in deteriorating balance sheets might compel financial institutions facing standardized advantage ratios to regulate their portfolios (Lessambo, 2013, p. 31). This would include attempting to hoard capital and liquidity apart from adjusting assets as much as practice activities do not aim at selling assets at depressed prices. However, it is important to note that an attempt by most financial institutions to hoard capital or liquidity simultaneously has the potential to cause financial instability. Trading activities by JP Morgan may cause concerns concerning policy and market resources affecting systematic risks. Records show that JP Morgan took the initiative to invest in thinly traded markets as well as those prone to liquidity losses. Therefore, efforts by the company to liquidate its position will affect other players in the industry and market negatively. Examples of Systematic Risks A paradigm example of financial instability is a Bank run. Many reasons including both meager and major erode the confidence leading to most bank depositors to demand for payments at equivalence. Such circumstances force banks to liquidate intrinsically illiquid investments under depressed values. Financial institutions considered in the same toxic asset level suffer from contagion arising from other institutions. A financial market collapse is an example of systematic event. Non-systematic Risk Scholars refer to the non-systematic risk using other terminologies include residual risk and specific. It is a company particular risk inherent in firms. The specific risk only applies to specific investments as opposed to the systematic risk that influences the whole market. It is a component of price risk that enough diversification in a particular asset level minimizes its presence (Compensation & benefits management, 2004, p. 19). This qualifies its definition as a specific business risk relating to fundamental stock. Accountants identify various examples do illustrate specific risks. The residual risk influences a group of assets small and single assets. Introducing a hitherto competitor is an example of a specific risk faced by a firm. These risks are peculiar to particular companies and assets making other academicians refer to them as idiosyncratic, unique, or asset-specific risks. Uncertain conditions about the general state of the economy including the interest rate, GNP, and inflation come out as perfect examples of specific risks. In many ways, these conditions influence all companies (Daft, 2011, p. 53). Surprise in inflation for instance, influences the levels of costs of supplies and wages associated with business companies. This directly affects the value of assets owned by firms. The situation does not spare prices either. These forces influencing all companies in the market provide the essence of systematic risks. On the contrary, when workers in oil companies post a notice to on strike only affects identified companies in addition to few suppliers and competitors related to the firms. Its effect in the entire oil industry and market remains negligible and this describes a non-systematic risk. Components of Return Clarity in the differences between specific and systematic risks does not appear as professionals attempt to define them. In most cases, even the slightest tension in a company ripples within the entire economy. Significant in this case understands that each enterprise forms part of the economy irrespective of its size. Some risks are greater in magnitude compared to others. Comprehending differences among various risks permits people to disintegrate the surprise portion touching on the return on expected shares into two different sections. It is essential for professionals to internalize diversification between the two risks to avoid an institution from experiencing great losses affecting either the industry or one participant in the market. The source could be financial calamity or any other. If the entrepreneur has a big percentage of the portfolio invested within the particular firm or industry, then the specific risk becomes an important aspect. One of the examples in this source is the collaterized debt. The terminology defines the process of borrowing to build an investment as well as using the same investment as a security to secure a loan. The mortgage presents the house as a security for the loan. Economists and other scholars posit that a decline in market prices directly leads to borrowers defaulting. This is despite the fact that when lenders take advantage of the situation of taking the collateral to shield their losses, they provide more of the new investment better for sale defying the decline in prices. The initiative of the investor would be balancing the effects of unsystematic risk to avoid wiping a portfolio completely by a single occurrence. This is the reason behind professionals encouraging diversification. However, it is a complicated venture to balance a systematic risk since companies and industries cannot avoid losses emanating from important big news within the political and financial world. The best thing for companies is to comprehend that means of hedging the losses exist. To protect the company against calamities that affect the entire economy, then it is advisable for investors to put money in business organizations and sectors with the capacity to manage all seasons including during financial difficulties compared to others. Long-standing significant products and business operations as well as services and products remain the most appropriate examples of investments with minimal losses during hard economic times. In many ways, these conditions influence all companies. Surprise in inflation for instance, influences the levels of costs of supplies and wages associated with business companies (Gleeson, 2012, 96). This directly affects the value of assets owned by firms. The situation does not spare prices either. These forces influencing all companies in the market provide the essence of systematic risks. Diversification secures a business company against unsystematic risks (Bamberg, & Klaus, 2007, p. 151). This is besides isolated diversification that appears the best method of controlling the levels of systematic risks developing in a particular investment. In summary, entrepreneurs need to put at the back of their minds that elements of risks exist in every type of investment. Portfolio Theory and Strategy Scholars aver that portfolio theory is a complicated methodology towards investment that strives to fully utilize the return for any given level risk. Other academicians refer to it as modern portfolio theory while others call it the modern investment theory. According to the theory, the risk associated with any form of stock is best examined through the correlation of the price of the stock to variation within the market portfolio. This type of portfolio puts together all elements of assets in the market holding every of the asset to the right ratio with regards to its value in the market. The theory helps any investor find out the interaction of various assets as opposed to the performance of individual assets. Any portfolio strategy has two primary questions. The questions are what are the financial goals of the company? How can the company attain the goals? In this case, scholars hold that the first question appears more direct and easy to respond to compared to the second question that appears complex. To address the two questions, the analyst ought to be conversant with various theories as well as their application during everyday business operations. It is important for anybody to understand that the theories apply across the board with limited or no restrictions. This is true irrespective of the size of the account of the business. Modern portfolio theory explains the concept of portfolio diversification clearly. Harry Markowitz, the Nobel Economist developed the theory in the mid twentieth century in nineteen fifty-two. It still stands out as one of the greatest developments in the history of the discipline. The theory contains a series of mathematical structuring as well as imperfect assumptions. Economists and other scholars posit that a decline in market prices directly leads to borrowers defaulting. This is despite the fact that when lenders take advantage of the situation of taking the collateral to shield their losses, they provide more of the new investment better for sale defying the decline in prices The theory entails tradeoffs existing between return and risk as one of its core concepts. While offering the definition, Markowitz held that the more risk an investor is willing to take, the higher the chances of receiving greater returns. Notably, is that various types of investments show same degrees of return and risk. The theory considers each broad category as an asset class. The asset classes include among others fixed income, equities, and real assets as well. Real assets are commodities and real estates. Important here is that particular assets naturally carry higher risks compared to others. These types of assets contain higher expectations in terms of returns. There is no perfect correlation among asset returns. It is possible that equities may fair poorly at the time that fixed assets do well on the market. The capacity of a single entity to pose systematic risk comes from the ability to create contracts and relationships with others magnifying and spreading upsets within the financial system. Accountants apply the terminology domino effect during occasions when interconnectedness leads to failure of one entity to result in the failure of part of counterparts and creditors. Several conditions of the market have various influences on various investments. An investor applies the knowledge gained in risk and return as well as the correlations of the two to explain the amalgamations of investments leading to the highest degree of return for any kind of the risk. Conclusion Every investor ponders about risks in addition to returns in the process of selecting an appropriate investment. As earlier identified however, it is not easy to define a risk in simple ways. Covered in the paper includes the value of comprehending the differences between a specific risk and a systematic risk, which helps the entrepreneur to the right decisions. The decisions cover among others first-timer and pro during investment processes. The systematic risk puts together all likely sources of instability within the financial system. It covers much more than failures in a single firm big enough. The systematic risk may lead to increased public policy concerns since it does not occur in the interest of specific financial organizations to consider the full likelihood of costs of the risks due its actions. It is not easy to insure against all types of systematic risks. The systematic risk that comes out as the first risk remains intrinsic in participating in the entire stock market. Different factors that influence the entire stock market affect the systematic risk. They include political changes, wars, and inflations. They influence the entire financial world as opposed to a specific industry, company, and individual investor. On the other hand, scholars refer to the unsystematic risk as the specific, unique, idiosyncratic, and residual risk referring to a risk that only applies to a particular company within the industry. Examples of this risk include among others product recalls, product returns, poor performance, office calamities, as well as employee strikes. Also noted in the paper is that diversification plays a pivotal role in minimizing losses when a calamity strikes. Bibliography Bamberg, G & Klaus, S (2007). Agency Theory, Information, and Incentives. Berlin: Springer-Verlag. Chingos, P. T. (2002). Paying for performance: A guide to compensation management. New York: Wiley. Compensation & benefits management. (2004). Greenvale, NY: Panel Publishers. Daft, R. L. (2011). Management. Chicago: Dryden Press. Gleeson, S. (2012). International regulation of banking: capital and risk requirements. Chicago: Dryden Press. Jensen, M & Meckling, W (2006). Theory of the Firm, Managerial Behaviour, Agency Costs, and Ownership Structure. Journal of Financial Economics 3 305-360. Lessambo, F. I. (2013). The international banking system: capital adequacy, core businesses and risk management. Houndmills, Basingstoke, Hampshire, Palgrave Macmillan. Milkovich, G. T., Newman, J. M., & Gerhart, B. A. (2014). Compensation. New York: McGraw-Hill/Irwin. Myers, D. W. (2009). Compensation management. Chicago, Ill. (4025 West Peterson Avenue, Chicago 60646: Commerce Clearing House. Read More