Systematic risk
Also written Non-diversifiable risk · Undiversifiable risk
The part of an investment's risk that comes from economy-wide forces moving every asset at once — it cannot be diversified away, and it is the only risk the market pays you to carry.
In plain language
Things go wrong in two different ways.
Some are about one company: a factory burns down, a founder leaves, an order is cancelled, the accounts turn out to be false. Hold thirty shares and these cancel out — one company's disaster is another's windfall.
Others hit everything at once: interest rates rise, a monsoon fails, a global credit market seizes, a war begins. No amount of diversification escapes these, because there is nowhere within the market to hide. That is systematic risk.
How it works
Total risk splits in two, and the split has a direct consequence for what an investor is paid.
Unsystematic risk can be removed for free, simply by holding more names — most of the benefit arrives by about 15 to 25 shares spread across sectors. Because it can be removed at no cost, the market does not compensate anybody for bearing it.
Systematic risk cannot be removed at any price, so it is the only risk that carries a return. This is the entire foundation of CAPM: expected return is a function of beta, which measures systematic risk alone, and standard deviation — total risk — does not appear in the equation at all.
The formula
Total risk = Systematic risk + Unsystematic risk
Systematic component of a share's risk = β × σ(market)
A worked example
An investor holds Rs 50 lakh across four IT services companies and calls it a diversified portfolio. It is not: every holding is exposed to the same rupee-dollar rate, the same US client budgets and the same visa regime.
Say the portfolio's standard deviation is 24% against the Nifty's 16%, with a beta of 1.15.
A company-specific shock. One holding loses its largest client and falls 30%. At a 25% weight that costs the portfolio 7.5%, or Rs 3.75 lakh. Spread the same money across twenty shares in six sectors and the identical event costs 1.5%, or Rs 75,000. The risk was removable, and the investor chose not to remove it.
A market shock. The RBI raises rates unexpectedly and the Nifty falls 12%. At a beta of 1.15 the portfolio is expected to fall 13.8%, or Rs 6.9 lakh — and here the twenty-share portfolio fares no better. There is no arrangement of Indian equities that avoids this loss. That is the difference between the two risks, in rupees.
Why NISM asks about it
Chapter 12 (Fundamentals of Risk and Return) sets out the two components, and the distinction then carries the whole of CAPM. Expect classification questions — you are given events and asked which are systematic — and the conceptual point that diversification cannot reduce systematic risk, which is examined almost every sitting.
Common exam traps
- Classify by cause, not by size. A strike at one company's plant is unsystematic however large the loss; a 25 basis point repo change is systematic however small.
- Diversification reduces unsystematic risk only. Any option claiming it reduces or eliminates systematic risk is wrong.
- Beta measures systematic risk; standard deviation measures total risk. The two are not interchangeable.
- "Systematic" is not "systemic". Systemic risk is the risk of the financial system itself failing — a related idea with a different meaning.
- Twenty shares in one sector is not a diversified portfolio. Correlation is what matters, not the count.
Check yourself
1.Which of the following is classified by the workbook as an UNSYSTEMATIC risk?
- a)Interest rate risk
- b)Reinvestment risk
- c)Credit risk
- d)Inflation risk
Show the answer
Answer: (c) Credit risk
The workbook gives two explicit lists. Systematic (undiversifiable): market risk, inflation risk, exchange rate risk, interest rate risk and reinvestment risk. Unsystematic (diversifiable): credit risk, business risk and liquidity risks.
Credit risk is unsystematic because an investor can reduce it by changing what she holds — the workbook's Ashima "can reduce credit risk by increasing the proportion of highly-rated bonds in her portfolio".
Interest rate risk, reinvestment risk and inflation risk are all on the systematic list. Interest rate risk is the one to be most careful with: if rates rise, the price of every bond Ashima holds falls, so no amount of rearranging within bonds helps.
2.An investor has placed a significant portion of his wealth in one particular investment and has not adequately diversified. Which risk-adjusted return measure is appropriate for appraising that investment?
- a)Treynor ratio
- b)Sharpe ratio
- c)Jensen's Alpha
- d)Modified duration
Show the answer
Answer: (b) Sharpe ratio
The workbook assigns the two ratios to two different investors, and the exam tests exactly this split.
Sharpe Ratio is appropriate for appraising the investment performance of individuals who have invested a significant portion of their wealth in a particular investment, and have not adequately diversified.
Treynor Ratio is appropriate for individuals who have adequately diversified their wealth into multiple asset classes.
The logic is worth carrying rather than memorising. Sharpe divides by standard deviation, which measures total risk — and an undiversified investor still carries unsystematic risk, so total risk is what matters to him. Treynor divides by beta, which measures only systematic risk — appropriate once diversification has removed the rest.
Option C measures excess return over the CAPM expectation, which does not depend on how the investor's own wealth is arranged. Option D is a bond interest-rate sensitivity measure, not a risk-adjusted return measure at all.
3.Which statement about market risk is correct as per the workbook?
- a)Deposits and small savings schemes have no market risk, but they also do not gain in value due to market factors
- b)Market risk affects all investments equally, including bank deposits
- c)Market risk arises only in equity shares, not in bonds or gold
- d)Market risk can be eliminated by holding a diversified portfolio of equities
Show the answer
Answer: (a) Deposits and small savings schemes have no market risk, but they also do not gain in value due to market factors
The workbook: "Market risk affects those investments which have an active secondary market, and the transactions happen at current applicable prices, such as equity, bonds, gold, real estate, among others. Investments such as deposits or small savings schemes are not marketable securities, and the investor gets a pre-defined amount on maturity. They have no market risk; but they also do not gain in value (or appreciate), due to market factors."
Market risk is "the risk of the loss of value in an investment because of adverse price movements in an asset in the market". The workbook's examples are a rate rise pushing bond prices down, and a rupee appreciation cutting the earnings expectations of exporters.
Why the others are wrong:
- Option B contradicts the carve-out above. Non-marketable deposits carry no market risk.
- Option C is too narrow. The workbook lists equity, bonds, gold, real estate as exposed.
- Option D contradicts the classification. "Market risk, Inflation risk, exchange rate risk, interest rate risk and reinvestment risk are systematic risks", and systematic risks "cannot be eliminated through diversification."
Where this is taught
- Series XXI-B · Chapter 16: Introduction to Capital Market Theoryintroduced here
- Series XV · Chapter 12: Fundamentals of Risk and Returnintroduced here
- Series V-D · Chapter 10: Risk, Return and Performance of Fundsintroduced here
- Series XVII · Chapter 5: Evaluating Fund Performance & Fund Selectionintroduced here
- Series V-B · Chapter 7: Performance of Mutual Fundsintroduced here
- Series XXI-A · Chapter 10: Performance Measurement and Evaluation of Portfolio Managersintroduced here
- Series X-A · Chapter 16: Portfolio Performance Measurement and Evaluationintroduced here
Related terms
- BetaHow sharply a share moves relative to the market index — beta 1 moves with the index, above 1 amplifies it, below 1 dampens it. The standard measure of systematic risk.
- CAPMA model that prices the return an investor should demand from a share: the risk-free rate plus beta times the market risk premium.
- Sharpe ratioReturn earned above the risk-free rate divided by standard deviation — how much reward an investment produced for each unit of total risk its holder had to live with.
- Standard deviationA measure of how far returns typically stray from their own average — the standard statistic for total risk, counting company-specific and market-wide causes alike.
- AlphaThe return a fund earned above what its beta and the benchmark say it should have earned — the slice of performance left over once the market has been given credit for its share.
- Market-Neutral StrategyA Category III AIF strategy taking equal long and short exposures within a sector, industry or market-cap segment so that portfolio beta is zero or close to zero.
- Arbitrage Pricing TheoryA multifactor alternative to CAPM, developed by Stephen Ross, in which expected return depends on several risk factors — each with its own beta — instead of the market alone.
- Parametric VaRValue at Risk estimated from just two parameters — expected return and standard deviation — assuming returns are normally distributed.
- Market ProxyA practical stand-in for the theoretical market portfolio — usually a broad-based equity index. The choice matters: an incorrect proxy distorts beta and the security market line.
- Single-factor modelThe workbook's own term for CAPM: a model that explains an asset's return using just one risk factor, market risk, unlike the several factors used in APT and other multifactor models.
- Undervalued securityUnder CAPM, a security whose estimated return plots above the Security Market Line — earning more than its systematic risk (beta) warrants under market equilibrium.
- Regression of beta toward the meanAn empirical finding in the tests of CAPM: high-beta portfolios tend to drift down towards 1.00 over time, and low-beta portfolios tend to drift up towards 1.00.
- Risk treatmentThe action a portfolio manager takes when a risk event occurs — tolerate it, mitigate it, transfer it, or terminate the activity — chosen on the nature, severity and frequency of the event.
- RiskThe possibility that actual returns turn out different from what was expected — measured as the dispersion of returns around their own average, and not the same thing as uncertainty.
- Market riskThe risk of loss from movements in market prices — one named category in a manager's risk framework, alongside credit, liquidity and operational risk, and the one measured with VaR and stress tests.
- Risk premiumThe extra return an investor demands over the nominal risk-free rate as compensation for uncertainty about future cash flows — the last and largest block in the required rate of return.
- Modern Portfolio TheoryMarkowitz's framework for building portfolios on expected return and risk together, in which the co-movement between holdings — not their individual riskiness — decides the risk of the whole.
- Market PortfolioThe tangency portfolio M of all risky assets worldwide in market proportions — the one risky portfolio every rational investor holds once a risk-free asset exists; indices serve as its proxy.
- Security Market LineThe graph of CAPM: expected return plotted against beta. In equilibrium every asset lies on it — a security plotting above is undervalued, one plotting below is overvalued.
- Reinvestment riskThe risk that the coupons or other intermediate cash flows from an investment have to be put back to work at a lower rate than the original investment earned, pulling the total return below the promised yield.
- Systemic riskThe risk that one participant's default triggers defaults by others until the settlement system itself fails — the domino risk, not the market risk.
- DiversificationSpreading an exposure across holdings that do not move together, so that total risk falls by more than total return does — minimising risk per unit of return.
- Country Risk PremiumThe extra return an investor demands for putting money into one country rather than another, added to the required rate of return to pay for that country's political and macroeconomic risk.
- Portfolio betaThe weighted average of the betas of the holdings in a portfolio — the measure of its systematic, non-diversifiable risk used in CAPM, the Treynor ratio and market-neutral strategies.
- Beta ManagementThe manager's job of keeping a fund's systematic risk in line with the strategy stated in its private placement memorandum, rather than letting the portfolio beta drift with the market.
- Unsystematic riskThe part of an investment's risk that belongs to one company or one issuer — a strike, a fraud, a downgrade — and which diversification can remove, unlike market-wide systematic risk.
- Treynor ratioRisk premium per unit of market risk — the return a scheme earned above the risk-free rate, divided by its beta rather than by its standard deviation.
- Actively managed fundA scheme whose fund manager chooses the portfolio within the broad limits of the investment objective, aiming to beat its benchmark — at a higher running cost than a passive fund.
- Exchange Rate RiskThe risk that an investment’s value, measured in the home currency, changes because foreign exchange rates move. A falling rupee raises returns on foreign assets; a rising rupee cuts them.
- Geopolitical riskThe risk that international conflicts, sanctions, trade disputes or diplomatic tensions disrupt trade, supply chains and investor confidence, causing market volatility and losses.
- Cross sectional diversificationHolding equities across different industries, sectors and geographies at a given time, so that sector- and company-specific risks offset. It cannot remove market risk.
- Sector-specific riskThe risk tied to one industry, distinct from broad market risk. It is unsystematic, so it can be reduced by holding securities from other, unrelated sectors.
- Short hedgeA hedge made by selling futures to protect an existing holding or a planned sale against a price fall — the futures gain offsets the lower cash price, locking in roughly the futures price.
- Hedge ratioThe number of futures (or options) needed to hedge a position. For one stock with its own futures it is 1:1; for a portfolio against index futures it is portfolio value × beta ÷ contract value.
- Index derivativesDerivative contracts — chiefly index futures and index options — that have a stock index as the underlying asset. In India they are cash settled and used to hedge market risk.
- Cross hedgeHedging an exposure with futures on a different but closely associated asset, because no futures contract exists on the asset itself — for example, hedging a stock portfolio with index futures.