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Systematic Risk - Essay Example

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Systematic Risk

Another definition put forward by Billio et al states that “any set of circumstances that threatens the stability of or public confidence in the financial system” (2010)
Another facade of examining systematic risk is to view it from the position of assets in a given corporate entity. Smart and Megginson identify that “systematic risks simultaneously affect many different assets, whereas unsystematic risks affect just a few securities [or assets] at a time.” (2008: 225).
This definition creates a distinction between systematic and unsystematic risks. The main difference is that systematic risks affect all the assets that a given company holds at the same time. It is a pervasive financial risk that affects all the assets a firm holds. This is different from unsystematic risk which is unique to a specific class of assets. This implies that systematic risk can be eliminated by investing in different assets and balancing the financial risks of the different asset classes. This is known as diversification.
Systematic risk is unique by the fact that it cannot be controlled by diversification. It involves financial risks that are pervasive on the financial market (Smart and Megginson, 2008). That is the reason why systematic risk is described as market risk. This is because it is an inherent risk that affects all assets in the economy.
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It is a pervasive financial risk that affects all the assets a firm holds. This is different from unsystematic risk which is unique to a specific class of assets. This implies that systematic risk can be eliminated by investing in different assets and balancing the financial risks of the different asset classes. This is known as diversification. Systematic risk is unique by the fact that it cannot be controlled by diversification. It involves financial risks that are pervasive on the financial market (Smart and Megginson, 2008). That is the reason why systematic risk is described as market risk. This is because it is an inherent risk that affects all assets in the economy. Systematic risks can only be controlled by investing in risk-free securities like government bonds and treasury bills (Lee, 2006). This is because the risk-free securities are uninfluenced by the things that occurs in the markets. An example is the case of a treasury bill which is a perfect example of a risk-free security for a small company. A treasury bill's interest rate is fixed and cannot be changed by the externalities on the market. Due to this, it could be considered as a solution to the problem of systematic risks. Question 2: The Spread of Systematic Risk in a Financial System Madura identifies that systematic risk is the spread of finacnial problems among financial institutions and among financial markets that could cause a collapse in financial institutions (2012). Figure 1: Basic Diagram of the Development of Financial Risk to a Systematic Risk . According to Murphy (2012), systematic risk can be spread through the financial systems through one of four circumstances. These circumstances are as a result of a firm, person, government, ...Show more

Summary

Following the abrupt increase in home prices in the 2004-2006 period many financial institutions increased their holding of mortgages and mortgage-backed securities, whose performance was based on the timely mortgage payments made by home owners. …
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