In finance, there are many sources or types of Systematic Risk. Systematic risk refers to that portion of the total variability in return on investment caused by factors affecting the prices of all securities in the portfolio. Systematic risk is known as market risk.
Economical, political, and sociological changes are the sources of systematic risk. Their effect is to cause prices of nearly all individual assets like common stocks, bonds, and other securities in the market to move together in the same manner.
Systematic risk affects the economic or financial system as a whole.
Sources or Types of Systematic Risk
Systematic risk times called as pervasive risk may include the sources which are categorized under the following means:
Market risk:
The price of common stock changes occur frequently in the process of buying and selling by the investor or speculator in the market place. The price of a stock may fluctuate daily and cyclically even though earnings maintain unchanged and some common stocks have a seasonal pattern.
Because of the changes in the market prices of the stock the investors can lose money. Variability in return on most common stocks that is due to basic sweeping changes in investor expectations is referred to as market risk.
Expectations of lower corporate profits in general may cause the larger body of common stocks to fall in price. Investment prices vary because investors vacillate in their preference for different forms of investments or simply because they sometimes have money to invest and sometimes do not.
The extensive vagaries of the stock market, the uncertainty and slowness of real estate markets, and the irregular markets for mortgages and second-grand bond issues all illustrated in the presence of market risk.
types of Systematic Risk
Interest-rate-risk:
Interest-rate-risk may be defined as the fluctuation in the market price of fixed-income securities owing to changes in levels of interest rate. Fixed-income securities mean notes and bonds, mortgage loans, and preferred stocks paying a definite amount of interest or dividends annually to investors.
Interest is the price paid for the use of money and like other prices fluctuates with demand and supply forces operating in the market.
The degree of fluctuation in the market prices of fixed-income securities resulting from interest-rate risk depends firstly on the amount of change in interest rates.
With any change in the market rate of return on a bond, the market price of stocks changes inversely. The second factor affecting the degree of fluctuation is the length of the period of maturity.
Every business or price of the property is subject to the possibility that its earning power or usefulness may wane because of competition, change in demand, uncontrollable costs, managerial error, government action, or some similar circumstances.
types of Systematic Risk
Purchasing power risk:
Purchasing power risk is the uncertainty of purchasing power of the amount to be received. It refers to the impact of inflation or deflation on an investment. Rising prices of goods and services are normally associated with what is referred to as inflation.
On the other hand, falling prices of goods and services are termed deflation. Purchasing power risk or inflation risk has received considerable publicity in recent years.
When an investor holds his surplus funds in the safety deposit box, he suffers from purchasing power risk. The risk of loss of income or principal because of decreased purchasing power of money is also known as purchasing power risk.
For some investors, purchasing power risk is very important. Individuals or institutions using their income to buy goods and services are greatly concerned over any changes in the purchasing power of their income.
Investors who fear inflation usually invest partially in common stocks and real estate with the hope that will rise in value. Rationale investors should include in their estimate of expected return, an allowance for purchasing power risk, in the form of an expected annual percentage change in prices.
Default risk:
Another source of systematic risk is default risk. This type of risk arises because firms may eventually go bankrupt.
Default risk seems to be undiversifiable or uncontrollable as it is systematically related to the business cycle affecting all most all investments even though some default risk may be diversified away in a portfolio of independent investments.
types of Systematic Risk
Exchange rate risk:
The chance that return will be affected by changes in rates of exchange because investments have been made in international markets whose promise to pay dividends, interest, or principal is not denominated in domestic currency risk or exchange risk.
Exchange rate risk is the uncertainty due to the determination of an investment in a country other than that of the investor’s own country.
The likelihood of incurring this risk is becoming greater as investors buy and sell assets around the world, as opposed to only assets within their own countries.
Political risk:
Also called country risk, political risk is uncertainty due to the possibility of major political change in the country where an investment is located. The chance that returns will be affected by the policies and stability of nations is called political risk.
The danger of debt repudiation or failure to meet debt service, expropriation of assets, differences in taxes, restrictions on repatriating funds, and the prohibition against exchanging foreign currency into domestic currency are typical political risks.
Liquidity risk:
Liquidity risk is the possibility of not being able to sell an asset for fair market value. When an investor acquires an asset, he expects that the investment will mature or that it could be sold to someone else.
In either case, the investor expects to be able to convert the security into cash and use the proceeds for current consumption or other investment. The more difficult it is to make this conversion, the greater the liquidity risk.
types of Systematic Risk
Real estate risk:
Such types of systematic risks. is unique and generally not found in most investments rather than real estate. The specific risk inherited in real estate investments are given below:
As there is no continuous auction trading market, quoted price may not represent the intrinsic value of the property.
- It is more difficult to find a buyer and seller raising the cost of transacting.
- Real estate markets are inefficient as they are likely to be segmented.
- The cost of acquiring information is greater.
- Property value is more influenced by changes in the rates of interest than other equities.
- Returns on real estate assets are determined by the going rates on default-free assets.
- Real estate is less liquid than financial instruments.
