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Systematic Risk is a measure that quantifies volatility for a stock, but only the component related to the Market, or common factor risks that represent the Market, meaning it is uncorrelated with the company's stock specific risk.
Synonyms: non-diversifiable risk, market risk, common factor risk, common source risk.
Systematic Risk is separated from specific risk in a single-variable (Market) or multi-variable (multi-factor) linear regression. It can be computed for any of the three timeframes: historical, expected or forecast, but is mostly used in risk forecasting applications like portfolio optimization.
In the formula above, if you have a stock's total variance, benchmark variance, beta and standard error from the regression you can isolate the second term in parentheses which is the systematic variance. The Beta^2 above means beta is squared.
For context, it is common to review the percent of systematic risk relative to total risk to get a feel for how closely related a stock's return stream was to its benchmark. A related measure R-Squared helps with this interpretation.
Systematic risk is called non-diversifiable risk because by holding many stocks in a portfolio specific risk can be reduced, and all that is left over is the systematic risk associated with the ups-and-downs of the stock market, or benchmark, itself.
Ted: So systematic risk is also called
non-diversifiable, common factor and market risk?
Eve: Yep, there's a lot of job security in
risk management.
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True
False. High R-Squared translates to a higher proportion of systematic risk.
Still unclear on the Systematic Risk? Check out the Quant 101 Series, specifically Stock portfolio risk decomposition into systematic and specific risk.
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