Systematic risk means that the gains or losses arising from potential risks will occur more likely simultaneously for the entire portfolio and not for a particular type of asset. Losses due to general economic conditions are a systematic risk because they simultaneously affect all market companies. For example, when monetary conditions become tighter, interest rates for all companies rise. Therefore, if an insurance company insures firms against the risk of rising interest rates, it will not be able to diversify its portfolio by underwriting a large number of insureds since all firms will incur losses at the same time. Therefore, it is not possible to reduce systematic risk through portfolio diversification.
Unsystematic risk is sometimes also called single company risk. This means that profits or losses in the portfolio of risk objects occur randomly. For example, building fires occur randomly, so the risk portfolio contains non-systematic risks. An insurance company can diversify the risk associated with building fires by insuring many buildings located in various locations. With a sufficient number of potential fire risk objects, an insurance company can predict its losses for any period with a high degree of accuracy and, therefore, determine an adequate size of the premiums.
In general, the risk is understood as the possibility of some adverse event, which entails various kinds of losses (for example, physical injury, loss of property, income below the expected level, etc.). The existence of risk is associated with the inability to predict the future with 100% accuracy. Based on this, it is necessary to single out the main property of Risk: Risk occurs only in the future and is inextricably linked with forecasting, planning, and decision-making in general. Following the preceding, it is also worth noting that the categories of risk and uncertainty are closely related and are often used as synonyms.
However, there are specific differences between these concepts.
First, the risk takes place only in those cases when a decision is necessary (if this is not the case, there is no point in taking risks). In other words, the need to make decisions under uncertain conditions gives rise to risk; in the absence of such a need, there is no risk. Second, the risk is subjective, while uncertainty is objective. For example, the objective lack of reliable information about the potential volume of demand for manufactured products leads to a spectrum of risks for project participants. For example, the risk generated by uncertainty due to the lack of marketing research for an investment project turns into credit risk for the investor (the bank financing this investment project), and in case of non-repayment of the loan into the risk of loss of liquidity and further into the risk of bankruptcy. For the recipient, this risk is transformed into the risk of unforeseen fluctuations in market conditions. For each participant in the investment project, the manifestation of risk is individual, both in qualitative and quantitative terms.
Pure And Speculative Risks
Pure risks are something that we cannot influence by a management decision.
They are relatively permanent. Mathematical statistics and probability theory methods are widely used for their analysis and evaluation since their manifestation, as a rule, is stable over time or differs in a specific pattern. They imply the possibility of damage or, at best, “break-even” situations. The outcome can either be unfavorable or leave us in the same position before the event happens. There is no element of gain in any situation. Accidents, fire, theft, or injury may or may not occur.
Speculative Risks, unlike pure ones, are entirely determined by the management’s decision. They have a chance to win. For example, they are buying shares. Investing can lead to losses, a “break-even” situation. However, this is done because of the prospect of making a profit. These are the risks that we take to achieve some desired result. Pure risks can be insured while speculative ones cannot.
Risk Classification
The CAPM (Capital Asset Pricing Model) divides the risk into systematic and non-systematic. Systematic risk is associated with changes in the situation of the securities market under the influence of macroeconomic and political factors (increase or decrease in the refinancing rate, inflation, changes in government policy, etc.). All companies in each country are affected by these factors.
About Complete Controller® – America’s Bookkeeping Experts Complete Controller is the Nation’s Leader in virtual bookkeeping, providing service to businesses and households alike. Utilizing Complete Controller’s technology, clients gain access to a cloud platform where their QuickBooks™️ file, critical financial documents, and back-office tools are hosted in an efficient SSO environment. Complete Controller’s team of certified US-based accounting professionals provide bookkeeping, record storage, performance reporting, and controller services including training, cash-flow management, budgeting and forecasting, process and controls advisement, and bill-pay. With flat-rate service plans, Complete Controller is the most cost-effective expert accounting solution for business, family-office, trusts, and households of any size or complexity.
