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Based on the link of systematic and unsystematic risk, would it be right to say that, systematic risk could also be eliminated, at a portfolio where investments have negative correlation amongst them?
Such as having shares at BP and British Airways?
Systematic risk (or market risk) is risk due to general economic factors, such as the level of inflation or changes in the exchange rate.
A shareholder can ‘remove’ the unsystematic risk by creating a portfolio of shares on the basis that although each share individually has unsystematic risk, it ‘cancels out’ with the risk of other shares in the portfolio. We say that a well-diversified portfolio is one where the unsystematic risk has been completely removed. (i.e. diversified away)
Systematic risk exists in all companies and cannot be removed – all companies will be affected by, for example, the level of inflation. However, the level of systematic risk depends on the type of business and will be different for types of business.
Although each individual shareholder may not hold a well-diversified portfolio of shares, we assume that shareholders overall are well-diversified and that it is shareholders overall who determine the return given by a share (because it is they who determine the market value of the share). Capital Asset Pricing Model assumes therefore that it is the level of systematic risk that determines the required return from an investment.Thanks – however, my question was not wrt to the link between sys ans unsys, it fairly understandable that sys risk are driven due to the economical “market” condition, hence, should you invest at negatively correlated investements, such as British Petro. and British airways, should the economic condition turn in favour of petro. you will have worse returns from the airline industry as whole, nonetheless, you would have had hedged your invest through returns from BP – thus negatively correlated…
Developing on the same concept hence, I would repeat my question if by having negatively correlated investment can we eliminate sys risk as well?
Correlation is for unsystematic risk only, as it is for diversification purpose.
Systematic risk cannot be diversied away, but unsystematic risk can be diversified away. How much can diversify depending on correlation between the investments.@auditorzonlin dazhong0703 is not a tutor so I don’t know why he is answering questions in this forum!
I understand the point that you are making. However, although you may think that airline companies and oil companies (and it is the business sectors we are looking at – not so much the individual companies) should be negatively correlated, in fact in practice if you look at the figures they are not. Overall all sectors go up and down as the market average goes up and down (to different degrees, which is what the beta is measuring) and they are not negatively correlated. (The only real example of negative correlation – which gives a negative beta – are shares in gold mines, and as a result they give returns of less than risk free. However I would not worry about that for the exam!).
Where there is potential maybe to diversify systematic risk is by investing in shares in different markets (rather than all in the same country). However, more and more, stock markets in different countries and inter-related and the scope for international diversification becomes more limited.
Fantastic John! greatly appreciate your response, in particular, the time you had taken out to clarify it…I can justify the same to myself now!
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