How to calculate unsystematic risk is one of the topics covered in the Quantitative Finance Stack.
Unsystematic risk management is one of the concepts revolving around.In a very comprehensive manner, this article explains all that you need to know about unsystematic risk.
The answer is simple since the unsystematic risk is associated with the internal risk factors of the firm.Specific risk is one of the types of unsystematic risk.An unsystematic risk arises from an event that the business is not prepared for.
If the stock prices go up, a firm may make high profits.Some other firm's stock prices may go down because of low profits.
Unsystematic risk can be avoided.It is possible to buy shares of different companies in different locations in your portfolio.Not all businesses will invest in face adversity because of unsystematic risk.The unsystematic risk which is unique to a few stocks is avoided.
The graph shows that an unsystematic risk is more if you don't have a diversified portfolio.Your unsystematic risk goes down as you invest in more than one stock.
The factors that can not be avoided are interest rate hike and inflation.
The outbreak of the coronaviruses can be used as an example.The financial markets suffered a lot of losses.
The definition of unsystematic risk will be discussed to make it clear what this type of risk means.
You invested $100,000 in your portfolio on 1st January, which is a diversified portfolio, and the investment goes as follows:
Since there was an annual growth of 14.5% on total investment, the total value of the portfolio is $114,531.
You can see a calculation after breaking down the investments in your portfolio.
If you only invested in the financial services sector, the return on your investment would be much lower.
You earned a 14.5% hike on your $100,000 investment because the companies like CISCO System, Apple, and Amazon did well.
Diversification of the portfolio can eliminate unsystematic risk because it is not correlated with the market risk.
This way, you mitigated the unsystematic risk which gripped few companies such as Citibank, Ford, and the like because of internal issues.
Unsystematic risk is represented by a firm's coefficients.The volatility level of stock in the financial market is the only factor that matters.
You can find your stock's alpha on a website such as Yahoo finance.On Yahoo finance, Apple Inc. has a 1.17 alpha, compared to Microsoft's 0.93 alpha.
Since Microsoft is less volatile than Apple, more investment can be made in Microsoft and less in Apple.
We will use the following formula to calculate the risk of your investment portfolio.
The percentage of total investment is divided by the amount of investment.
With the help of following formula, you can find out the alpha of each investment.
The measurement of how two stocks move together is called covariance.When the prices of stocks go up or down, it is a positive covariance.It is a negative covariance if they move away from each other.
There is a measurement of the price of a stock over a period of time.This is the measurement of a stock in relation to its mean.
Great!We will find out how to calculate the unsystematic risk so that we can mitigate it.
Calculating the unsystematic risk is easy and can be measured by the amount of systematic risk in your investment portfolio.The one which depends on macroeconomic factors is systematic risk.These factors are not internal and can't be avoided.
Let's assume we're investing 40% in Apple and 60% in Microsoft.We will use this method to calculate the total alpha.
We have a total risk of 1.026 on the investment in the overall portfolio.
We can find out how the two types of risk are different.Unsystematic risk and systematic risk are different.
The non-diversifiable risk is the market risk which rises because of macroeconomic factors.The factors can be categorized into social, political and economic.Systematic risk is the risk of interest, inflation, or market risk to the firm.The entire industry is at risk from this kind of risk.
The returns of the firm can be affected by certain micro economic factors.If necessary actions are taken within the organisation, the risk factors can be avoided.
Labour strikes and mismanagement of operations are some of the reasons a firm may face adversity.
Business risks, financial risks and operational risks are some of the types of unsystematic risks.
Unsystematic risk can interfere with the normal operations if the organisation is not able to take care of any part.
Business risk is the type of unsystematic risk that questions whether the firm will be able to earn a considerable amount of profits or not.There should be at least as much earning as possible to cover the usual expenses of a business.They include salaries, marketing cost, and so on.
Financial risk is the use of financial leverage or loan that the firm may use for funding its operations.The firm is responsible for paying interest on the loan.The capital amount can be paid on the expiration date of the loan.It falls prey to the financial risk if the firm is not able to generate enough income to cover the loans and expenses.The risk is higher when a firm carries loan-related obligations.Failure to meet commitments related to leverage or loan can lead to insolvency.Some factors can make a firm vulnerable to financial risks.
The debt to equity ratio is a way of finalising the leverage amount for funding operations since it helps keep the debt lower than the equity.You won't end up increasing your liabilities.
Foreign currency exchange risk is a part of financial risk if your business is spread to foreign countries.Since you will be receiving your payments in that country's currency, a decrease in the value of a foreign currency can cause sudden losses.
The loss that every organisation is prepared to bear is implied by an operational risk.There can be an error.
To avoid hurting the organisation's finances, operational risk management needs to be set up.The number of operational errors or loss a firm is ready to incur should be determined.Correcting some of the errors can be done, but the firm must be prepared to pay for it.Total operational risk is a combination.
The operational errors, which lead to the operational risks, play a key role in the determination of programs which can help avoid such a risk.Disaster recovery programs and risk management programs are examples of such programs.The programs help to assess the potential risk factors, communicate the same and then come up with steps to mitigate them.
The next topic is how to mitigate business risk and financial risk.
The business risk and financial risk are more complex than the operational risk.The management is prepared to deal with operational risks.Since business risk and financial risk can lead to a huge loss for the organisation, it can't be the same.
Business risk can be mitigated by decreasing unnecessary cost and shifting to online marketing.
Financial risk can be mitigated by taking care of the finances, for instance, by calculating the debt/equity ratio and dividing the funding between debt and equity wisely.
Identifying and uncovering the risks associated with your business is what this means.These can be anything from overspending on marketing to fraud.
After you have identified the risks which your business is more vulnerable to, you can find out how severe the impact may be and then rank each risk based on the severity.The risks a business can accept are not detrimental to the business.Some risks need to be resolved at the earliest.If a crucial part of the business breaks down, it needs to be fixed immediately.It can wait until the important things are taken care of if a non-crucial part is down for maintenance.
If you rank the risks based on severity, you will be able to treat the most severe ones at the earliest.Once you are done taking care of the most severe ones, you can move to the less severe in the list.
The risks which were identified and resolved should be tracked and reviewed in the future.The leaders or managers can implement the solutions required if a team of employees is set up.
Do you know if your business can survive without certain expenses?It's better to hire full-time employee(s) for the work than toOutsource some occasional work such as researching the statistical data.
There are certain unforeseen events that should be insured for your business.The insurance acts as a safeguard and helps you save a lot of money.
The right business structure will allow you to spend only in the right places.Your employees will stick to the firm if you spend on nurturing talent.A good set of employees can help you in the long run, but if you don't need them, spending on full-time employees will increase your financial risk.