Steps Involved in Measuring Systematic Risk in Your Startup
August 14, 2021
If you’re familiar with marketing strategies and schemes or own a startup, you would have come across a term called systematic risk. Well, if not, what you should know is that it’s virtually that part of the total risk caused by factors that are beyond the control of a particular startup or individual. External influences are the major source of systematic risk in a startup. It affects all investments or securities and is, therefore, a non-diversifiable risk.
Below we’ll be looking at how to measure systematic risk in your market. However, before we talk about that, let's quickly look at the various types of risk.
5 Types of Systematic Risk
The herd mentality of investors or their desire to follow the market's direction usually causes market risk. As a result, market risk refers to the tendency for security prices to move in lockstep. When the market falls, even the stock values of well-performing startups fall. Furthermore, statistics have it that nearly two-thirds of total systematic risk is accounted for by market risk. As a result, systematic risk can also be called market risk.
Interest Rate Risk
Changes that occur in market interest rates can generate interest rate risk. As bond prices are inversely related to the market interest rate, fixed-income assets in the financial markets are greatly affected. There are two forms of interest rate risks: pricing risk and reinvestment risk, without a doubt. Both of these risks work in the other way. Variations in the price of securities as a result of interest rate changes are associated with price risk. Reinvesting interest income, on the other hand, increases the likelihood of reinvestment risk. Meanwhile, if price risk has a negative sign, reinvestment risk is said to be positive. As a result, the most primary source of risk associated with fixed-income assets like bonds and debentures is interest rate risk.
Purchasing Power Risk
Purchasing power risk occurs as a result of inflation. Inflation is an increase in the general price level that is consistent and continuous. Inflation diminishes the purchasing power of money, which implies that when prices rise, the same amount of money can buy fewer things and services. As a result, if an investor's income does not increase in tandem with inflation, the investor's income is reduced in real terms. Fixed-income investments are subject to a significant amount of purchasing power risk since their income is fixed in nominal terms. Equity shares, as is often said, are good inflation hedges and hence have a lower chance of losing purchasing power.
Exchange Rate Risk
Most startups in a globalized market are often exposed to foreign currencies. The uncertainty associated with the changes occurring in the value of foreign currencies is often known as exchange rate risk. As a result, this risk only affects the shares of startup(s) that deal with foreign exchange transactions, such as export enterprises, multinational corporations, or startup(s) that deal with imported raw materials or products.
When a country faces critical geopolitical issues, it can affect all of the country's startups. By investing in multiple nations, you may diversify your portfolio. However, if foreign investment is not permitted in the country and the domestic economy is threatened, the entire market of investable securities suffers losses.
Measurement of Systematic Risk
The beta coefficient (β) is usually used to calculate systematic risk. A greater beta coefficient indicates a higher level of systematic risk, whereas a lower beta coefficient indicates a lower level of systematic risk. The beta coefficient is calculated by regressing an investment's return on the performance of a wide market index. As a result, it's calculated as the weighted average of each investment beta coefficient. The capital asset pricing model calculates the required return on an equity investment based on the risk it entails. As can be seen from the formula below, the higher the beta value, the higher the necessary return, and vice versa.
Er = rf + β × (rm - rf)
Er = Expected required return
rf = The risk-free rate
rm = The return on the broad market index, and
β = Beta coefficient
Impact of Systematic Risk
The magnitude of beta can be used to determine the extent to which systematic risk affects the stock's return relative to market returns.
When the beta coefficient is equal to one (β = 1), it means the systematic risk has the same impact on stock returns as it does on the market.
When the beta coefficient is equal to zero (β = 0), it means the systematic risk has no impact on stock returns but impacts the market.
When the beta coefficient is less than one (β < 1), it means the systematic risk has a smaller impact on stock returns than it does on the market.
When the beta coefficient is greater than one, (β > 1), it means the systematic risk has a greater impact on stock returns than on the market.
Management of Systematic Risk
Asset allocation is usually the solution to systematic risk. If a market is affected by it, some of the portfolio's assets should be allocated to another market. While systematic risk cannot be eliminated by adding additional assets to a portfolio, it can be lowered through effective asset allocation.
Let's imagine you have a portfolio that includes stocks, bonds, real estate, and gold. It’s less risky than an all-equity or all-bond portfolio in terms of systematic risk. That’s because certain systematic risk factors have varying effects on different asset classes. A downturn in the stock market, for example, might result in favorable returns for gold. In this case, a well-balanced portfolio with several investment classes has a lower overall systematic risk exposure.
Hedging strategies can also be used to mitigate and eliminate systematic risk. For instance, a hedge fund that can be used to invest in equities investments might short sell the broad market index. The systematic risk associated with a positive position in individual stock investments may be canceled out by a negative position in the broad market index.
Systematic risk is a type of risk that affects the entire market and cannot be mitigated by diversification or security selection. Asset allocation is the only way to avoid it, and it entails investing in a variety of markets to supplement other markets that are exposed to systematic risk. However, it does not eliminate systematic risk; instead, it minimizes it to a degree.
Meanwhile, systematic risk can be measured using the beta coefficient, which involves the use of regression analysis, and statistics concepts to calculate. And this measure might differ from one analyst to the next, thereby introducing subjectivity into the analysis.
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