Systematic Risk - Properties of Systematic Risk

Properties of Systematic Risk

Systematic or aggregate risk arises from market structure or dynamics which produce shocks or uncertainty faced by all agents in the market; such shocks could arise from government policy, international economic forces, or acts of nature. In contrast, idiosyncratic risk (sometimes called specific risk, unsystematic risk, residual risk, or diversifiable risk) is risk to which only specific agents or industries are vulnerable (and is uncorrelated with broad market returns). Due to the idiosyncratic nature of unsystematic risk, it can be reduced or eliminated through diversification; but since all market actors are vulnerable to systematic risk, it cannot be limited through diversification (but it may be insurable). As a result, assets whose expected returns are negatively correlated with broader market returns command higher prices than assets not possessing this property.

In some cases, aggregate risk exists due to institutional or other constraints on market completeness. For countries or regions lacking access to broad hedging markets, events like earthquakes and adverse weather shocks can also act as costly aggregate risks. Robert Shiller has found that, despite the globalization progress of recent decades, country-level aggregate income risks are still significant and could potentially be reduced through the creation of better global hedging markets (thereby potentially becoming idiosyncratic, rather than aggregate, risks). Specifically, Shiller advocated for the creation of macro futures markets. The benefits of such a mechanism would depend on the degree to which macro conditions are correlated across countries.