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Systematic Risk Management

Ahmed Abdelsalam
Abu Dhabi University, Email: 1056272@students.adu.ac.ae
Saree Barake
Abu Dhabi University, Email: 1063765@students.adu.ac.ae
Saif Kulaib
Abu Dhabi University, Email: 1062269@students.adu.ac.ae

Supervised by:
Professor Haitham Nobanee

Abstract

The global recession in 2008 drew back the attention of investors, financial institutions, and

other stakeholders on the impact of systemic risk and systematic risks. The systemic risk was

initiated by the over-leveraged Lehman Brothers that led to the bursting of the real estate bubble

as the number of defaulters grew. The systematic risk that cut across all sectors of the economy

affected the business performance of numerous companies and markets. Therefore, studies

focused on the systematic risk management and the financial management practices that can

improve mitigation of the impact of systematic risk amidst the growing tension of a possibility of

another global recession, especially, at a time when most of the world is at a standstill due to the

pandemic of the novel coronavirus. This paper examines the different types of systematic risk,

the estimation of beta, and the management of systematic risk.

Introduction

Each investment made by a business entity or an individual has a specific risk attached to

it. The risk attached to investment is composed of both unsystematic and systematic risk. The

systematic risk which is also commonly referred to as the market risk or non-diversifiable risk is

caused by external factors that are not within the control of the business entity or organization or

individual (Tzang, Wang, & Yu, 2016). All investments including securities held by the

company are subject to systematic risk and, thus, they cannot be mitigated through the

diversification of the portfolio.

The most recent example of the systematic risk is the recent global recession towards the

end of the 2000s that cause an economic meltdown that reverberated across the world. The

global recession was caused by the fall of the Lehman Brothers that initiated a domino effect in

the financial markets from Wall Street to the rest of the world and led to numerous businesses

failing during that time (Mohohlo & Hall, 2018). The systematic risk faced by most markets

during that time was unavoidable and could not have been mitigated even if the companies had

diversified portfolios or held numerous securities in the different industries (Mohohlo & Hall,

2018). Therefore, there has been a significant focus by most of the companies as they try to

determine the better financial management strategies that can mitigate the impact of systematic

risk and how to enhance sustainable business performance amidst the threat posed by systematic

risk (Al Mheiri & Nobanee, 2020).

Literature Review

The best investment decisions are made based on the investor’s accuracy in the

estimation of the risks involved. Using financial information provided for in the financial
statements, one can predict the systematic risk of the investment and develop management

strategies that will enhance the business practice of the business firm creating sustainable

business operations (Almarar & Nobanee, 2020). Investors are usually risk-averse or risk-neutral

because they rationalize the quid pro quo between the risk in a specific portfolio and the

expected returns of the portfolio (Puspitaningtyas, 2017).

The risk and return correlation are always linear and positive. That is, the estimated risk

is directly proportional to the expected return of the portfolio. The higher the expected return the

risk and the lower the expected return the lower the risk involved in the investment (Sudarsono,

Husnan, Tandelilin, & Ekawati, 2012). Consequently, an investor expects to have the maximum

return possible on a portfolio with a given level of risk attached to the market. According to the

investment theory that is captured in the Capital Asset Pricing Model (CAPM) (Sudarsono,

Husnan, Tandelilin, & Ekawati, 2012), an investor considers only the risk that cannot be reduced

through diversification in a manner that only the systematic risk is relevant. The systematic risk

Systematic risk is part of the total risk that is accredited to a market segment or the entire

market (Sudarsono, Husnan, Tandelilin, & Ekawati, 2012). The risk can affect the company’s

portfolio and can cause massive selling of stock due to panic by the investors (Puspitaningtyas,

2017). According to Alaghi (2011), the financial leverage a firm possesses directly affects the

risk profile of the firm. If the firm experiences an increase in its financial leverage, the beta of its

equity also increases which increases the systematic risk (Alaghi, 2011). Moreover, the equity

beta is used to indicate the financial risk involved in a given investment while the asset beta is

used to indicate the business risk that the firm undertakes when it makes such investments (Kim

& Yasuda, 2018). Thus, it is clear that the systematic risk of a company is affected by its
financial leverage which allows investors to manage systematic risk by managing its financial

leverage in a given business.

Monitoring the movements of the measures of systematic risk could provide better

management for the risk (Patro, Qi, & Sun, 2013). In the stock markets, monitoring and

estimation of the stock market correlation can be significant in managing systematic risk because

it is an indicator of the systematic risk involved in stock markets (Patro, Qi, & Sun, 2013).

According to Patro, Qi, & Sun (2013), the risk environment for most investments has changed

over the years. The markets have become a high-risk environment as the financial markets have

transitioned into high systematic risk regime from low systematic risk regime since 1985 (Patro,

Qi, & Sun, 2013). Furthermore, they asserted that the global recession that began late in 2007

was a result of the transition and that the bursting of the housing market bubble was an inevitable

event that had not been monitored by focusing on the measures of systematic risk such as the

stock market correlation. However, it is important to note that the financial leverage is inversely

proportional to the operating leverage of a given portfolio while the tangibility and asset

profitability are negatively correlated to the long-term debts and positively correlated to the

short-term debts of the firm (Mohohlo & Hall, 2018). According to the study, the firms in South

Africa have reduced their financial and operating leverage since the global recession in 2008 so

much so that the operating leverage that most companies have does not affect capital structure

because the firms have increasingly become conservative in their investments (Mohohlo & Hall,

2018).

Tzang, Wang, & Yu (2016) inferred that there is no relationship between the beta value

os systematic risk and the option values. They also stated that there is a negative correlation

between the level of volatility of a given investment and the level of beta value of the systematic
risk (Tzang, Wang, & Yu, 2016). Therefore, it is prudent to state that the level of beta can affect

the volatility structure of a portfolio while the systematic risk proportion cannot determine the

shape of the inferred volatility curve (Tzang, Wang, & Yu, 2016). However, the systematic risk

proportion is proportional to the positive kurtosis and negative skewness of the volatility curve

(Tzang, Wang, & Yu, 2016).

Discussion and Results

Systematic risk includes interest rate risk, market risk, political risk, exchange rate risk,

and purchasing power risk. According to the capital asset pricing model, systematic risk can be

compensated if the company records higher returns.

Types of Systematic Risks

The interest rate risk arises from the changes in the interest rates of a given market. In the stock

market, the interest rate risk affects fixed income securities because the market interest rates are

inversely proportional to the bond prices. Further to that, the interest rates have two contrary

components that include reinvestment and price risks. The two interest rates risk components

work in opposite directions (Puspitaningtyas, 2017). The changes in the interest rate can

influence the changes in the price of fixed income security that is associated with price risk. On

the other hand, reinvestment risk is concerned with the reinvestment of dividend income or

interest. If the price of the security falls which can be translated as negative price risk, then the

investor will record an increase in the reinvested money, hence, reinvestment risk will be

positive (Puspitaningtyas, 2017). The interest rate risk is the source of systematic risk that

debentures and fixed income securities face in any market.

 The market risk that a company faces is caused by the tendency of investors in a given

market to follow the direction of the market causing the security prices in the market to move in

unison a phenomenon commonly referred to as herd mentality. That is, if the share prices for a

market a falling, then the share prices of performing stocks will also fall despite the prevailing

conditions that might allow the company to optimize the changes in the market. The market risk

poses the largest portion of total systematic risk and it is estimated that it poses about two-thirds

of the systematic risk. Therefore, systematic risk is at times referred to as market risk. The

changes in market price are the main source of risk in securities held by an investor.

The political risk stems from the political stability or lack thereof in a given nation or

region. If there is political unrest in a nation, the companies operating in the country or region

are considered to be at risk because the political unrest due to war or other factors will disrupt the

operations of the business and, thus, affect the markets (Puspitaningtyas, 2017). Subsequently,

markets should be aware of the change political climate so that it can adjust its business

operations to mitigate the impact of the political risk on its business performance.

Today, most companies operate in a globalized economy, hence, they are exposed to the

risk of exchange rates because they trade in foreign currency. The exchange rate risk is the

insecurity that is associated with fluctuations in the values of foreign currency (Alaghi, 2011).

The foreign exchange risk affects the investments of companies that have foreign exchange

transactions. Furthermore, companies that export or import finished goods or raw materials

respectively are also exposed to foreign exchange risks.

Inflation in a country exposes the market to purchasing power risk. Inflation is the overall

increase in the price level that has been persistent or sustained for a given period. The inflation

rate reduces the purchasing power of the investments in a market (Alaghi, 2011). That is, money
can only buy fewer services and goods due to an increase in prices. Therefore, if the investor’s

income does not increase as the prices of goods and services are increasing due to inflation then

the investor is making less income than he did before. Fixed income securities are exposed to

high purchasing power risks given that the income received from such investments is fixed in

nominal terms. Equities, on the other hand, are subject to lower purchasing power risks

compared to fixed securities because they are excellent hedges against inflation.

Estimation of Beta

Systematic risk management can be measured using the beta coefficient. The beta

coefficient is directly related to systematic risk. The higher the beta coefficient the higher the

systematic risk attached to a portfolio. If the beta coefficient is equal to 1 the investment is said

to have the systematic risk that is commensurate to the mean systematic risk of the market in

which the investment is made. A beta coefficient of zero indicates that the securities or portfolio

is uncorrelated to the market return while a beta coefficient greater than zero but less than one is

an indication of low volatility albeit the positive correlation between the securities with the

market return (Kim & Yasuda, 2018). Investors are always looking to establish excellent

financial management to allow them to practice sustainability in their business practices and,

thus, they focus on the beta coefficient to determine the risk (Alkaabi & Nobanee, 2019).

Volatility will be higher if the value of beta is higher than one which indicates that the portfolio

is more volatile than the market (Sudarsono, Husnan, Tandelilin, & Ekawati, 2012). Hence, the

beta coefficient can be estimated by regressing the return on a given portfolio on the expected

return on the market.

Knowing the value of the beta of a specific portfolio or security is crucial in the analysis

of a portfolio or security and it is essential in the formation of a securities portfolio. The portfolio
beta is calculated by first calculating the individual securities beta and the weighted mean of the

securities beta (Sudarsono, Husnan, Tandelilin, & Ekawati, 2012). The beta of individual

securities is estimated using accounting data and market data that is obtained from the historical

data of the company or market. The regression of the securities returns with the market return.

The securities return is the dependent variable while the market return is the independent

variable (Sudarsono, Husnan, Tandelilin, & Ekawati, 2012). The regression equation produces

the beta coefficient under the assumption that there is stability throughout the time series data

observation. Beta estimation is a two-fold process. First, the market return and stock return

should be calculated (Puspitaningtyas, 2017).

Ri,t = (Pi,t ↔ Pi,t-1)/ Pi,t-1

Where Ri,t represents a return on the stock in period t; P i,t is the price of the stock within

the same period, t (Puspitaningtyas, 2017).

Rm,t = (Rm,t – Rm,t-1)/ Rm,t-1

Rm,t is the return on the market of security over the period t.

Secondly, from the two equations, the regression between the return on a stock with a

return on the market provides the beta coefficient (Puspitaningtyas, 2017).

Ri,t = α + β Rm,t + ε

Where ε is the variable error.

Managing Systematic Risk

Systematic Risk can be managed through asset allocation that is accomplished through

the spreading of security across assets from different market segments and markets. The
correlation between the assets should be minimal so that they are dissimilar from the other

investments according to the portfolio theory (Puspitaningtyas, 2017)..

Source: (Puspitaningtyas, 2017).

From the graph above, asset allocation is explained further. In an investor invests solely

at point B then the risk will be high as well as the return. That is, the risk and expected return

will be at point B while if an investor solely invests at point A then the risk and expected return

will be at A. Low risk attracts low returns while high risk attracts high returns. If an investor

invests in both A and B which are very dissimilar investments then the blue line in the graph will

indicate the efficiency frontier. If the portfolio holder invests a large proportion in A and a

smaller proportion in B then the investment return is expected at E. The point E highlights the

increased returns with a lower risk involved. As demonstrated, using asset allocation

significantly reduces the volatility of the portfolio while it increases the expected return.

Therefore, the rate of return is dependent on the return or risk levels of each asset and the

number of holdings in the portfolio and the degree of correlation between the allocated assets

(Puspitaningtyas, 2017)..
 Hedging strategies will also enhance the mitigation of systematic risk. Hedging allows an

investor to go long in investments that the investor believes will increase in value in the future

and also go short on futures or securities that are likely to lose value so that the effects of interest

rates risk or exchange rate risks are mitigated.

Conclusion

The world recession that happened between 2007 and 2008 enhanced the focus of

experts on determining the impact of systematic risk to establish ways that can enhance the

management of such risk. Systematic risk is the threat to investment returns due to external

forces that include social-political, and economic factors that undermine the expected returns of a

given portfolio. Systematic risk is part of the total risk that is affected by factors that are outside

the control of the company and, thus, the mitigation of the risk cannot be enforced through

diversification of the portfolio. Furthermore, holding numerous securities cannot diversify the

portfolio enough to avert the impact of systematic risk. The beta coefficient is used to measure a

stock’s systematic risk. Consequently, some of the most common systematic risk management

strategies that have been effective include asset allocation and hedging of portfolios.

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