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Systemic Risk vs Market Risk: Understanding the Key Differences

Purchasing power risk, also known as inflation risk, is the type of risk that arises due to inflation. When inflation occurs, it decreases the value of money and investments because its lowers the value of the dollar, thus driving up the price of goods, services, and investments. Often times, an individual’s wage or salary does not keep up with the price of inflation, making it difficult for them purchase things, such as stocks. Purchasing power risk is most prevalent in fixed income securities because income from these securities is set to nominal terms.

But systematic risk cannot be diversified away, since entire markets are moving in sync. Understanding both types of risk is key for asset allocation and risk management in investing. Diversification works well for unsystematic risk, while hedging instruments like options are better suited to protect against market downturns from systematic risks. However, properly distinguishing between systematic and unsystematic risks enables more targeted risk management through diversification and hedging strategies. No single investor or institution has all pieces of the puzzle that is systemic risk.

1. If you do choose to purchase individual stocks you can diversify effectively with around 20 stocks of different large-capitalization companies, but you don’t need to do that.
2. This risk is inherent in any investment, regardless of the asset class, be it stocks, bonds, real estate, or commodities.
3. One factor captures worldwide variations of financial markets, another one the variations of European markets.
4. With forced liquidations in thin liquidity, the trades that offered the most convincing value positions (by conventional standards) suddenly incur the greatest mark-to-market drawdowns.
5. In corporate finance, the concept of risk that impacts the public equities market is segmented into two distinct categories.

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Systemic or cascading risk from hazard events occurring elsewhere was not part of their calculations. Most of them reported that they recovered from disasters by working longer and harder, and often using informal loans for recovery capital. Essentially, they were starting again each time a disaster hit, often with additional debt. In the hazard-prone territory of the Philippines, this meant they could not grow or build a secure business.

Nonetheless, with the onset of the COVID-19 pandemic, there is a growing sense of urgency for a paradigm shift. This is hitting every major twentieth century risk management institution, from governments to insurers. The limitations of the linear constructs of that era are now revealed, with the occurrence and prospect of massive failures across and between systems. They represent how complex components – such as interactions and interdependencies between disease spread vectors, human behaviour, health system infrastructure and other economic activities – are distributed across systems. This is known as distributional heterogeneity and additivity of extreme events. The global COVID-19 pandemic is an example of a low probability, extreme event.

What is Market Risk?

For example, if an investor has placed too much emphasis on cybersecurity stocks, it is possible to diversify by investing in a range of stocks in other sectors, such as healthcare and infrastructure. It cannot be mitigated through diversification, only through hedging or by using the correct asset allocation strategy. Systematic risk, also known as undiversifiable risk, volatility risk, or market risk, affects the overall market, not just a particular stock or industry.

A good way to mitigate or work against purchasing power risk is to invest in equity shares because they are less susceptible to inflation. Examples of systemic risk include the collapse of major financial institutions, contagion effects due to interconnectedness, or unexpected events that have a severe impact on the entire financial system, such as natural disasters. In summary, systematic risks arise from macroeconomic factors and affect the wider market, while unsystematic risks are unique to individual assets and can be managed through diversification.

Impact of Systemic Risk on the Economy

1. Understanding the distinction between systematic and unsystematic risk is critical with regard to risk management and reducing the potential for incurring monetary losses, not only for market participants such as investors, but also society as a whole.
2. Yet the long-term consequences of these types of events can be profound on the lives of consumers and businesses for years thereafter.
3. When a systemic crisis escalates the priority of institutions shifts from seeking returns to short-term capital preservation.
4. For example, if an investor has placed too much emphasis on cybersecurity stocks, it is possible to diversify by investing in a range of stocks in other sectors, such as healthcare and infrastructure.

A positive cascade of risk reduction awareness triggered by the Bangkok floods has thus permeated government policy and action and private sector engagement in other countries in the region. In the Philippines, it has energized new ways of working in “systemic risk reduction” to tackle a broad spectrum of local and regional disaster risks that affect SMEs’ business continuity and their contribution to socioeconomic development. Soon after it began in 2009, PDRF was formally recognized as the private sector coordinator to work with the Government.

Systematic risk can be mitigated through diversification, but the risk would still affect all investments in a particular market or economy. As a result, investors must be aware of the potential for systematic risk when making investment decisions and take steps to manage this risk through strategies such as asset allocation and risk management. For example, an increase in interest rates will make some new-issue bonds more valuable, while causing some company stocks to decrease in value. Making sure that a portfolio incorporates ample income-generating securities will mitigate the loss of value in some equities. To help manage systematic risk, investors should ensure that their portfolios include a variety of asset classes, such as fixed income, cash, and real estate, each of which will react differently in the event of a major systematic change.

Interest Rate Risk

Some of the characteristics of such institutions at the global scale types of systematic risk can be explored through examples from the global financial system and international climate change institutions (see Chapter 13). Enabled by increases in computational power and the availability and mobilization of vast streams of data and observations, models and narratives, systems approaches increasingly help make sense of the failure of linear constructs in a world where everything is connected. (Linear constructs refer to the pervasive extraction – production – distribution – consumption – disposal linear process of resource use in the current economic paradigm). Systems thinking is obvious and essential to create the future enshrined in the 2030 Agenda.

PreventionWeb is the global knowledge sharing platform for disaster risk reduction (DRR) and resilience. If appropriately co-produced, systemic risk modelling will uncover the incentives driving policymaker resistance to going beyond conventional views of risk and those allowing salient early warnings from systemic risk indicators to be ignored or rejected. By accounting for different factors, one captures the notion that shocks to the US or Asian markets may affect Europe, but also that bad news within Europe (such as the news about a potential default of one of the countries) matters for Europe. Also, there may be country specific news that does not affect Europe or the US, but matters for a given country. Empirically the last factor is less relevant than the worldwide or European factor.

This investor is vulnerable to systematic risk but has diversified away the effects of idiosyncratic risks on his portfolio value; further reduction in risk would require him to acquire risk-free assets with lower returns (such as U.S. Treasury securities). By integrating risk management practices that address both systematic and unsystematic risks, investors can build robust portfolios positioned to weather different market environments. The keys are assessing risk exposures, diversifying strategically, and rebalancing prudently.

FX trading signals: Common sense and machine learning

It can be captured by the sensitivity of a security’s return with respect to the overall market return. In the same project, an analysis of the enabling environment made up of legislative and policy frameworks in the Philippines was conducted. In a sense, Philippine MSME resilience was “everybody’s business” and “nobody’s business”, and yet the situation clearly required a systems response.

The approach differs from multi-hazard modelling which relies on “regularity assumptions”. These attempt to make reality less complex and disorderly to ease calculation. Determining the right strategic asset allocation suitable to an investor’s risk appetite and investment timeframe is key to managing systematic risk.