Section 14.1 – Systematic vs. Nonsystematic Risk

  • All investments carry risk.

  • Risks can be broadly divided into systematic and nonsystematic risks.
    Some risks overlap, but generally:

    • Systematic risk = affects the entire market/economy

    • Nonsystematic risk = affects a specific company or industry

🌀 Systematic Risk:

  • These are market-wide risks that cannot be diversified away.
    Even a highly diversified portfolio is still subject to systematic risk.

  • Main Types of Systematic Risk:

  • Market Risk

    • Risk that the entire market declines.

    • When the market index (like S&P 500) falls, most portfolios fall too.

    • Diversification cannot protect against it.

  • Interest Rate Risk

    • Affects bonds and other fixed-income securities.

    • When interest rates rise, existing bonds with lower rates fall in price.

    • When rates fall, existing bonds with higher rates increase in price.

    • Longer maturities fluctuate more than shorter maturities — this sensitivity is called duration.

  • Inflation Risk (Purchasing Power Risk)

    • Rising prices reduce the purchasing power of fixed income.

    • Affects fixed-income investments (like bonds).

    • The opposite, deflation, makes fixed payments more valuable.

    Example:
    An investor earns 5.5% annually from a 30-year bond.
    If inflation rises, that $5.50 buys less over time — reducing real returns.

💼 Nonsystematic Risk:

  • Also called specific or diversifiable risk.

  • These risks affect one company or industry and can be reduced through diversification.

  • Types of Nonsystematic Risk:

    Credit (Default) Risk

    • Risk the issuer fails to make interest or principal payments.

    • Common with debt securities.

    • Also called financial risk or default risk.

  • Capital Risk

    • Risk of losing the original investment.

    • Varies by security type.

    • U.S. Treasuries = virtually no capital risk; options = very high risk.

  • Business Risk

    • Risk of poor management or bad decisions.

    • Can lead to lower earnings or even bankruptcy.

    • Affects common stockholders most.

    • Example: A company’s failed marketing leads to falling sales and stock price.

  • Liquidity (Marketability) Risk

    • Risk of being unable to sell quickly at fair value.

    • Highly liquid: listed stocks, bonds, mutual funds.

    • Illiquid: real estate, art, limited partnerships.

  • Regulatory Risk

    • Risk of new rules or enforcement changing a company’s operations.

    • Example: new environmental or data protection regulations.

  • Legislative Risk

    • Risk that new laws, such as tax code changes, hurt certain businesses.

  • Political Risk

    • Risk of instability or regime change affecting businesses in a country.

    • Common in emerging markets.

  • Sovereign Risk

    • Risk that a country defaults on its debt.

    • Can cause global market impact.

⚖️ Other (Mixed or Overlapping) Risks:

  • Some risks are not easily classified as systematic or nonsystematic.

  • Call Risk

    • Risk that a bond is called early when interest rates fall.

    • Investor loses higher-yielding bond and must reinvest at lower rates.

    • Call protection = time during which bond cannot be called.

    • Applies to callable bonds and callable preferred stocks.

    Example:
    Investor holds a callable 5% bond. Rates drop to 3%, issuer calls bond → investor must reinvest at 3%.

  • Reinvestment Risk

    • Related to interest rate and call risk.

    • When rates fall, it’s hard to reinvest proceeds or interest payments at the same yield.

  • Prepayment Risk

    • Risk that borrowers pay off loans early.

    • Common in mortgage-backed securities like GNMAs.

    • Early principal return means reinvestment risk for the investor.

  • Currency (Exchange Rate) Risk

    • Applies to foreign investments.

    • If foreign currency weakens vs. U.S. dollar, value of investment declines.

    • Currencies trade at the spot rate (current market value).

Risk

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Risk 〰️

Quick Summary Chart

Type of Risk / Systematic or Nonsystematic / Description

  • Market Risk / Systematic / Market-wide decline affects all securities

  • Interest Rate Risk / Systematic / Bond prices move opposite to rate changes

  • Inflation Risk / Systematic / Rising prices reduce real returns

  • Credit Risk / Nonsystematic / Issuer may default

  • Business Risk/ Nonsystematic Poor management/operations

  • Liquidity Risk / Nonsystematic / Can’t sell quickly/fairly

  • Regulatory/Legislative / Nonsystematic / New laws or rules

  • Political/Sovereign / Nonsystematic / Instability or default by country

  • Call/Reinvestment/Prepayment / Mixed / Tied to changing interest rate conditions

  • Currency Risk / Mixed / Depends on global markets

✺ Review questions ✺

  • Systematic risk affects the entire market and cannot be diversified away; nonsystematic risk affects specific companies or industries and can be reduced through diversification.

  • Interest Rate Risk.

  • Purchasing Power Risk.

  • Credit Risk (Default Risk).

  • Business Risk.

  • Systematic Risk.

  • Call Risk.

  • Prepayment Risk.

  • They increase in value because fixed payments can buy more goods and services.

  • Currency (Exchange Rate) Risk.