systematic vs unsystematic risk economic, understand, specific, question, everyone

lxwarr30

Hello everyone,

I have a quick question with regards to systematic vs unsystematic risk. I understand that unsystematic risk is risk that can be diversified away. However, I'm having a hard time figuring out if a specific risk is systematic or unsystematic.

For example: (quoted from the schweser CFA book)

"the high risk of our biotech stock, however, is primarily from firm-specific factors, so its unsystematic risk is high. since market factors such as economic growth rates have little to do with the eventual outcome for this stock, systematic risk is a small proportion of the total risk of the stock."

since most of the risk is from firm specific factors, i'm assuming this to be inherent risk in the company (related to business model, etc) and not from broader economic factors.. thus it cannot be diversified away.. as a result, systematic risk should be high not low as stated in the book.

thanks for any help you can offer.

Jolyn

You got the part about the firm specific factors being the inherent risk in the company. But this infers that unsystematic risk is high, not the systematic risk.

Here's the explanation:

-systematic risk is the risk that all firms have in the market therefore even if you have a portfolio of company stocks that are negatively correlated, you cannot diversify away this risk.

-unsystematic risk is the opposite in that it is the risk that is specific to the firm (specific risk=unsystematic risk) so that if you invest in firm stocks that are negatively correlated, you diversify away the risk.

Then, for the example you quoted from Schweser, the reasoning is that the Biotech stock's risk can almost all be attributed to how the firm does rather than how the market or economy does. Since this risk is specific to how the firm will perform, this type of risk is firm-specific=unsystematic risk. So, the unsystematic risk is high. In contrast, even if the market is sh!tty, if the firm does well, then the firm's stock will invariably rise, which means the market risk (or systematic risk) has little to do with Biotech's stock price, thus the systematic risk is low.

Hope that helps!

LokiDog2

@gooner: Thats correct

Daniel1985

rockstar Wrote:
-------------------------------------------------------
> You got the part about the firm specific factors
> being the inherent risk in the company. But this
> infers that unsystematic risk is high, not the
> systematic risk.
>
> Here's the explanation:
>
> -systematic risk is the risk that all firms have
> in the market therefore even if you have a
> portfolio of company stocks that are negatively
> correlated, you cannot diversify away this risk.
>
> -unsystematic risk is the opposite in that it is
> the risk that is specific to the firm (specific
> risk=unsystematic risk) so that if you invest in
> firm stocks that are negatively correlated, you
> diversify away the risk.
>
> Then, for the example you quoted from Schweser,
> the reasoning is that the Biotech stock's risk can
> almost all be attributed to how the firm does
> rather than how the market or economy does. Since
> this risk is specific to how the firm will
> perform, this type of risk is
> firm-specific=unsystematic risk. So, the
> unsystematic risk is high. In contrast, even if
> the market is sh!tty, if the firm does well, then
> the firm's stock will invariably rise, which means
> the market risk (or systematic risk) has little to
> do with Biotech's stock price, thus the systematic
> risk is low.
>
> Hope that helps!


This was absolutely golden. Thank you so much for explaining this.

I was originally under the impression that systematic risk was firm specific risk, when in fact that is unsystematic risk. systematic risk is basically how correlated your firm's performance is to the overall market's performance, right?