Risk and Return

Sources or Types of Unsystematic Risk

What is Unsystematic Risk? Sources or Types of Unsystematic Risk

Sources or Types of Unsystematic Risk. A portion of total risk that is unique or peculiar to a firm or an industry above and beyond that affecting the securities market, in general, may be termed as unsystematic risk.

Read: What is Unsystematic Risk?

Management capability, consumer preference, and labor strikes are the elements of unsystematic risk.

Sources or Types of Unsystematic Risk

However, the unsystematic risk of investment consists of two major components:

credit risk and

sector risk

Credit risk:

Credit risk sometimes called company risk consists of business risk and financial risk. Business risk is the risk inherent in the nature of the business.

On the other hand, financial risk is the risk in addition to business risk arising from using financial leverage.

Credit risk is associated with the ability of the firm that issues securities to meet its promise on those securities. The fundamental promise of every investment is a return commensurate with its risk.

So the credit risk analyzed is the ability to deliver returns that are consistent with the risk assumed. However, business risk and financial risk are discussed below:

Types of Unsystematic Risk

Business risk:

The loss or income on capital associated with the ability of some companies to maintain their competitive position and maintain their earnings growth is sometimes referred to as business risk.

Common stock and to some extent preferred stock and bonds posses this risk.

The risk that results is either temporary or permanent. The business risk is not only associated with the weaker companies that have suffered a total loss but also happened in the case of some quality companies when a deficit in earnings or a sharp drop in earnings was sustained which resulted in substantial losses to investors.

In other words, business risk is defined as the change that the firm will not have the ability to compete successfully with the assets that it purchases.

For example, the firm may acquire a machine that may not operate properly, that may not produce salable products or that may face other operating or market difficulties that cause losses. Any operational problems are classed as business risk.

Types of Unsystematic Risk

Business risk can be divided into two categories:

external and internal. Internal business risk is largely associated with the efficiency with which a firm conducts its operations within the broader operating environment imposed upon it.

On the other hand, external business risk is the result of operating conditions imposed upon the firms by circumstances beyond its control. Each firm faces its own set of external risks, depending upon the specific operating environment factors that it must deal with.

Financial risk:

Financial risk is associated with the way in which a company finances its investment activities. It may be defined as the change that an investment will not generate sufficient cash flows to cover interest payments on money borrowed to finance it or principal payments. the debt or to provide profits to the firm.

We usually gauge financial risk by looking at the capital structure of a firm. The presence of borrowed money in the capital structure creates fixed payments in the form of interest that must be sustained by the firm.

Financial risk is an avoidable risk to the extent that managements have the freedom to decide whether to borrow or not to borrow funds.

A firm with no debt financing has no financial risk.

Types of Unsystematic Risk

Sector risk:

Sector or industry risk refers to the risk of doing better or worse than expected as a result of investing in one sector of the economy instead of another.

Sector investing implicitly acknowledges that the impact of individual investment decisions is less critical, certainly too large portfolios than investing in the proper sector at the proper time.

Sector rotation is a portfolio management style shifting resources to sectors that are expected to be more promising and are overweighed in a portfolio in contrast to other sectors which are underweighted.

As the number of stocks in the portfolio is increased, the unsystematic or residual risk of the individual securities is diversified away leaving only the systematic or market-related risk.

We assume that all rational profit-maximizing investors want to hold a completely diversified market portfolio of risky assets and they borrow or lend to arrive at a risk level that is consistent with their risk preferences.

Under such conditions, the relevant risk measure for an individual asset is its comovement to the market portfolio. This comovement measured by an asset’s covariance with the market portfolio is its systematic risk.

Finally, we may draw a conclusion as we can divide total risk into two components viz., a general or market component and a specific or issuer component. An investor can construct a diversified portfolio and eliminate part of the total risk called diversifiable or nonmarket risk.

The systematic risk known as non-diversifiable or market risk is directly associated with overall movements in the general market or economy. 

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