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Systematic Risk

Systematic risk refers to the part of the total variability in return on investments that is due to factors affecting the entire market or economy. This type of risk is inherent to all securities in the market and cannot be diversified away.

Characteristics of Systematic Risk:

  • External Factors: Arises from economic, political, and social factors that are external to a company or industry.
  • Uncontrollable: It is out of the investor's control due to its widespread impact.

Examples of Systematic Risk:

Market Risk

  • Changes in overall market conditions can affect the price of securities across the board.

Interest Rate Risk

  • Variations in interest rates impact the market activity, investor perceptions, and the value of securities.

Purchasing Power Risk

  • Inflation and changes in the cost of living can erode the real value of returns.

Trade Cycles and Business Conditions

  • Economic cycles, such as recessions or booms, can impact the performance of investments.

Unsystematic Risk

Unsystematic risk is specific to a company or industry. It encompasses the variability in returns due to factors unique to the particular entity.

Characteristics of Unsystematic Risk:

  • Internal Factors: Includes elements like management failures, labor strikes, and raw material shortages.
  • Controllable: Since it is related to specific factors, it can often be mitigated through proper management and strategies.

Examples of Unsystematic Risk:

Business Risk

  • Linked to the performance and operations of an individual company or industry.

Financial Risk

  • Associated with the financing methods of a company, such as high leverage or liquidity issues.

Management Risk

  • Inefficiency or errors within the company's management team can lead to underperformance.

Labour and Input Risks

  • Problems with labor or supply chain can affect a company's production and profitability.

Default Risk or Insolvency Risk

  • Definition: The risk that a borrower or issuer of securities becomes insolvent or defaults on payments.
  • Impact: Can result in an investor receiving no returns or incurring losses.

Other Risks

Management Risk

  • Poor management decisions can lead to losses.

Marketability Risk

  • Loss of liquidity or difficulty in converting assets without a loss in value.

Political Risk

  • Changes in government policies, tax rates, or regulations can affect investments.

Risk and Risk Aversion

Investors' attitudes towards risk can be broadly categorized as risk-averse or risk-seeking.

Risk Aversion

Risk-averse investors prefer investments with lower risk, such as:

  • Bank deposits
  • Mutual funds
  • Debentures
  • Government securities

Risk Seeking

Conversely, risk-seeking investors may prefer higher-risk investments, including:

  • Equities
  • Company fixed deposits
  • Venture funds
  • Startups or new companies

Understanding the different types of risks and investors' risk tolerance is crucial for financial planning and investment decision-making.

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