Explain the difference between systematic and unsystematic risk, and why one of

Question

Explain the difference between systematic and unsystematic risk, and why one of these types of risks is rewarded with a risk premium while the other type is not.

Unsystematic, or diversifiable, risk affects a limited number of securities and can be eliminated by investing in securities from various industries and geographic regions. Unsystematic risk is not rewarded because it can be eliminated by investors. Systematic risk is risk that affects most, or all, securities and cannot be diversified away. Since systematic risk cannot be eliminated by investors it is rewarded with a risk premium. Systematic risk is measured by beta.

Explanation / Answer

Unsystematic risk is the risk associated with the company specific issues,its specific to a particular company.For e.g the bankruptcy proceeding might go through or not,whether the business projects are profitable and other risks associated with the management and other company ventures.

Systematic risk is the risk associated with the macro environment that is the economy ,it measures how much the company stock fluctuates with respect to the fluctuations in the market index with the fluctuations in the economy due to changes in various macro variables as inflation,interest rate or GDP growth.The higher the systematic risk indicates that stock moves or changes by a larger percentage as compared to market index with the changes in economic conditions and a lower  systematic risk indicates that stock moves or changes by a lesser percentage as compared to market index with the changes in economic conditions,therefore in a sense the Systematic risk indicates how sensitive the stock is to changes in the economic conditions or the changes in the market index values.The risk arising out of the changes in economic conditions that could result in adverse movements in the stock is called systematic risk.The systematic risk is measured by Beta=Covariance between the market and stock returns divided by the variance of the market.

The Systematic risk is rewarded with a risk premium because its not possible to diversify away it,it is the risk inherent in the stock which should be rewarded with a risk premium for bearing this risk.The premium awarded =Beta*Market Risk Premium,This risk premium is higher the higher the Systematic risk or Beta and is lower the lower the Systematic risk or beta.The unsystematic risk on the other hand can be diversified away fully therefore it should not be rewarded by a risk premium,rather the company specific issues related to industries,regions,products does this risk arises.

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