Systematic Risk

The complement of nonsystematic risk is systematic risk.

Systematic risks affect an entire market or a specific segment of that market.

Systematic risk factors are far reaching and impact all companies to some extent. These factors are not unique to the investment under consideration. They will harm a company regardless of how the company operates or manages its risks.

Systematic risk may also be known as nondiversifiable, non-controllable, or market risk.

In this post we will review a few key systematic risks that often affect investors.

Note that it is not an exhaustive list.

Interest Rate Risk

Interest rate risk reflects how changes in interest rates may affect a company or investment.

Individual companies have no control over interest rate fluctuations. Interest rates move based on a variety of high level factors, including: governmental monetary and other policies; Central Bank actions; supply and demand of money and credit; general economic conditions.

A company’s actions do affect their own credit worthiness and the rates that they pay relative to the benchmark (Prime, LIBOR, etc.) but they have no material influence on the benchmarks themselves. That is why interest rate risk is a systematic risk and not a nonsystematic risk.

Why is interest rate risk an issue for companies and investors?

As interest rates rise, the cost of borrowing increases for companies.

For example, last year a $10 million bank loan may have resulted in a 5% variable interest rate. So a company would have paid the bank $500,000 in interest. If general interest rates rise to 8% this year, the company will need to pay the bank $800,000 in interest payments.

That is $300,000 less money available for reinvestment in the business, paying suppliers and other creditors, or being available for interest or dividend payments to investors.

It is also $300,000 less in profits. Earnings are often a key figure used to value companies. With less earnings, the company and its public shares may also be worth less.

Inflation Risk

Inflation risk is the risk that the price of goods and services will rise, thereby reducing the purchasing power of your assets. Inflation risk is usually linked with interest rate risk as interest rates will normally rise as inflation increases. Or rates will rise as governments or central banks attempt to contain inflationary pressures.

Imagine that you need to purchase a specific set of textbooks, materials, and supplies for school in six months time. You can buy them all today for $1000 or you can wait until the school semester begins. You notice that your bank is offering a six month term deposit with a 3% return for the period. You figure that an extra $30 in interest will buy you a few coffees on campus, so you deposit your money with the bank.

Over the next few months you read in the paper about concerns in the Middle East impacting oil prices. The economy is also heating up and the newspapers are using the word “inflation”. A concept that was covered in the economics class you missed with a hangover.

When the semester starts and the term deposit matures, you take your $1030 and head to the local coffee shop with a stop at the bookstore on the way. You collect all the required items and go to the checkout to pay the $1000. You receive a bit of a shock when the bill totals $1050. Not the $1000 that it should have been.

The clerk, by coincidence an economics graduate, explains that during the past six months inflation has rose 5%. As a result, the general cost of living has increased and goods cost correspondingly more money.

That is inflation risk. Unless the return on your assets meets or exceeds the inflation rate, the value of your assets will fall.

As an investor if you invest your cash in fixed income instruments, you need to be aware of expected inflation rates. This is why “real return” is a very important benchmark.

For example, in late 2008 I could recommend an investment that would easily double in 30 days. In fact I would guarantee that return. Sounds good, no?.

But what if I told you that the investment was based in Zimbabwe which was experiencing a monthly inflation rate of 79,600,000,000% (no, not a typo). At that rate, prices double every 24.7 hours.

Even though you would double your Zimbabwe dollars in one month, they would have lost their entire purchasing power in only one day.

While the rest of the world may not be Zimbabwe, on smaller scales this regularly occurs.

Be careful.

Reinvestment Risk

Reinvestment risk arises primarily due to the impact of interest rate changes.

It is the risk that total returns are altered due to a shift in interest rates.

For example, you have $10,000 that you intend to invest for 5 years in a Guaranteed Investment Certificate (GIC) issued by your bank. You can purchase a 5 year GIC that offers a 5% compound interest rate. However, you notice that the 1 year GIC offers a 7% rate. You decide to buy the 1 year GIC now and then purchase another at the end of the year.

At year end you receive $10,700. You reinvest in another GIC, but the best rate you can find is for 1 year at 4%.

That is reinvestment risk. The risk that when you go to reinvest your income you cannot obtain the same rate as you received on the initial amount.

This is a common issue for bond or dividend income.

In much of the world today, this is a real problem for retirees who live on fixed income from investments. As interest and dividend rates fell, income for retirees also decreased. And while inflation in North America has not been a major factor, prices never go down. This has caused financial difficulty for many of the elderly.

Like all risks though, there is potential upside to reinvestment risk, not simply downside.

Perhaps you own a 30 year bond paying 3% annually in cash interest payments. There may be periods during which market interest rates rise and you are able to reinvest at higher levels.

When we look at fixed income investment strategies, we will consider methods to address reinvestment risk. If you cannot wait, google “fixed income ladder” for one simple and effective method.

Currency Risk

Each country has a currency with which goods and services are paid.

Some countries share a common currency.

A single currency, the Euro, is shared by 19 of the 29 European Union Member States. The Euro is also the official currency for a few additional smaller countries, states, and territories.

Some countries maintain their own currency but have it “pegged” (i.e. linked) to another country’s currency. The pegging may be a one to one ratio or something completely different.

The Bahamas pegs their currency on an equal basis to the US dollar. In fact, payments can be made in either currency without a problem. And when you get money back, it can be a mix of Bahamian and US dollars. In the Cayman Islands (CI), 1.00 CI dollar is pegged at 1.227 US dollar (1.00 USD = 0.80 KYD). Payments may be made in US dollars at the official exchange rate, but any cash returned will be in CI dollars (there are a few exceptions in certain tourist shops).

Other countries take the pegging concept a step further and actually adopt the currency of another country. For example, Ecuador eliminated its own currency and adopted the US dollar as its official currency.

Finally, some countries let their currency “float”. A specific currency will float like a boat on the ocean. The country’s economic fortunes, as compared to its own expectations and the forecasts of other countries, will rise and fall over time. The country’s currency, by its movements, should reflect these relative changes in prosperity.

Well that is the theory. In reality, individual countries attempt to control the value of their currencies based on premeditated actions taken by the country and/or its central bank.

Currency risk can greatly affect investors in the global marketplace.

Perhaps you are an American investor who buys CAD 10,000 in 5 Year Government of Canada bonds with a 6% coupon interest rate paid annually.

Being an American investing in Canada you must consider both base and local currencies.

The base currency is usually your own domestic currency. The home market in which you operate. The local currency is the currency of the foreign market in which you are investing. In this example, the American’s base currency is the USD. The local currency is the CAD.

Note that for a Spaniard investing in a Moscow real estate project, the base currency is the Euro and the local currency the Russian ruble.

At the time of the investment, CAD 1.00 equals USD 0.80, so you pay USD 8000 for the bonds. Over the 5 years you will receive annual interest payments of CAD 600 and after 5 years, you will receive CAD 10,000. Cumulatively you will have received CAD 13,000; CAD 3000 in interest and CAD 10,000 in repayment of capital.

But what if the CAD has depreciated over the 5 year investment period? At the end of each year the CAD/USD exchange rate is 0.75, 0.68, 0.73, 0.64, 0.58. The interest you receive, assuming you immediately convert it back to USD, will only amount to USD 2028. The maturing bond will be worth USD 5800. This results in a total return of USD 7828.

You actually lost money on this simple fixed income transaction.

Thieving Canadians!

Sociopolitical or Geopolitical Risk

The risk that instability in one or more regions of the world negatively impacts investments. War, terrorism, health scares are examples of this risk.

Wars in Africa continually impact markets in the region and spill over to international companies and consumers who rely on those markets and products.

Consider the global market reaction to the September 11, 2001 terrorist attacks. Regardless of the industry or company, there was a high probability the company’s shares fell that day.

Or how about the Severe Acute Respiratory Syndrome (SARS) scare in 2002. There was a tremendous impact in companies operating in Asia (and certain other areas), not to mention on tourism and export operations.

Individual companies had done nothing different in their operations. But the above risk occurrences may have had significant impact on their business and profitability.

That is an overview of both nonsystematic and systematic risks.

I hope you found it interesting and informative.

Next we shall look at the generic tools available to address risk in business.

After that, consideration of how to address risk as an investor.

Then we shall move on to looking at investment returns and asset classes.