In finance, systematic risk, sometimes called market risk, aggregate risk, or undiversifiable risk, is the risk associated with aggregate market returns.
By contrast, unsystematic risk, sometimes called specific risk, idiosyncratic risk, residual risk, or diversifiable risk, is the company-specific or industry-specific risk in a portfolio, which is uncorrelated with aggregate market returns.
Unsystematic risk can be mitigated through diversification, and systematic risk can not be.[1]
Systematic risk should not be confused with systemic risk, the risk of loss from some catastrophic event that collapses the entire financial system.
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For example, consider an individual investor who purchases $10,000 of stock in 10 biotechnology companies. If unforeseen events cause a catastrophic setback and one or two companies' stock prices drop, the investor incurs a loss. On the other hand, an investor who purchases $100,000 in a single biotechnology company would incur ten times the loss from such an event. The second investor's portfolio has more unsystematic risk than the diversified portfolio. Finally, if the setback were to affect the entire industry instead, the investors would incur similar losses, due to systematic risk.
Systematic risk is essentially dependent on macroeconomic factors such as inflation, interest rates and so on. It may also derive from the structure and dynamics of the market.
Given diversified holdings of assets, an investor's exposure to unsystematic risk from any particular asset is small and uncorrelated with the rest of the portfolio. Hence, the contribution of unsystematic risk to the riskiness of the portfolio as a whole may become negligible.
In the capital asset pricing model, the rate of return required for an asset in market equilibrium depends on the systematic risk associated with returns on the asset, that is, on the covariance of the returns on the asset and the aggregate returns to the market.
Lenders to small numbers of borrowers (or kinds of borrowers) face unsystematic risk of default. Their loss due to default is credit risk, the unsystematic portion of which is concentration risk.
At the portfolio level, unsystematic risk can be diversified away whilst systematic cannot be diversified away.
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