An investment portfolio’s total risk is composed of systematic risk and unsystematic risk.
Systematic risk (also called non-diversifiable risk or market risk) is the risk that affects the whole system. It is a risk that cannot be avoided by diversification because it is inherent in all assets. Examples of factors that lead to systematic risk include inflation, interest rate, economic cycles, etc. The use of leverage magnifies the systematic risk and adding assets that have a low correlation with the portfolio, may diminish it.
Unsystematic risk is the risk that is limited to a particular asset or industry. These include risk factors that are local to a company and need not affect other companies. Unsystematic risk can be avoided by creating portfolios of assets that have a low correlation.\[ Total\ Variance = Systematic\ Variance + Unsystematic\ Variance \]
According to the capital asset pricing model, only systematic risk is compensated in the form of a higher expected return. It is because investors can easily diversify away the unsystematic risk. Hence, compensating them for both systematic and unsystematic risk would create an arbitrage opportunity. In other words, only the systematic risk is priced. It follows that investors should hold diversified positions to avoid a risk for which they do not earn any additional return.
Which of the following would least likely be a source of systematic risk?
A) Bank run
B) Outbreak of a virus damaging orange crops
C) Widespread political upheaval.
B is correct. Since the outbreak of a virus affecting orange crops is relevant to only one industry, it is least likely systematic in nature.
Risks which are compensated in the form of higher expected return include:
A) Systematic risk
B) Unsystematic risk
A is correct. Only systematic risk is compensated because it cannot be diversified away.
The statement that the total risk of a portfolio is the sum of its systematic risk and unsystematic risk is true in terms of:
B) Standard deviation
A is correct. Total variance of a portfolio equals the systematic variance plus the unsystematic variance. This cannot be stated for the standard deviation.