Analysis of Systematic and

Unsystematic Risks in Capital Markets

Submitted by-
Nigel Karl Vas 0920820
Nishant Edwin Paschal 0920821
Pavan Kumar Sarma 0920822
Ravi Teja J 0920920
Remin Francis Saldanha 0920921
 Capital Markets
The market for long-term funds where securities such as
common stock, preferred stock, and bonds are traded.
Capital markets may be classified as primary
markets and secondary markets.
Primary markets -new stock or bond issues are sold to
investors via a mechanism known as underwriting.
Secondary markets - existing securities are sold and bought
among investors or traders, usually on a securities
exchange, over-the-counter, or elsewhere.
 Risk: Systematic and Unsystematic
We can break down the total risk of holding a stock into two components:
systematic risk and unsystematic risk:
 Systematic Risk
• Systematic Risk or market risk or non –
diversifiable risk determined be
Macroeconomic factors (affect the whole
economy), such as:
• Business cycle
• Inflation cycle
• Interest cycle
• Exchange cycle
 Unsystematic Risk
Unsystematic Risk or unique risk or firm-specific
risk or diversifiable risk determined by Firm-
specific factors, such as:

 Firm’s successful R&D

 Management’s style and philosophy
 Analysis
For Systematic Risk
• CAPM is a model that predicts the expected return on each risky
asset.
• Security Market Line (SML): visually represent the relationship
between systematic risk and the expected or required rate of
return on an asset.
• The risk measure of the asset is its systematic risk measured using
beta (β).
E(Ri) = RFR + βi(RM-RFR)
• β is standardized because it divides an asset’s covariance Cov(i,M)
with the market portfolio by the variance of the market portfolio
(σM2).
• RM-RFR: is the market risk premium
Capital Asset Pricing Model (CAPM)

Method for predicting

how investment returns
are determined in an
efficient capital market
Captial Asset Pricing Model(CAPM)
• CAPM uses the concept of beta to link risk with return. Using
CAPM, investors can assess the risk return trade off involved
in any investment decision.
• Beta is a measure of non-diversifiable risk (systematic risk). It
shows how the price of security responds to changes in
market prices.
The beta coefficient, b, tells us the response of the stock’s return
to a systematic risk.
In the CAPM, b measures the responsiveness of a security’s
return to a specific risk factor, the return on the market
portfolio.
 Formulae
CAPM
Re= Rf +  ( Rm – Rf)
Where,
Re= cost of equity
Rf= risk free return
 = beta of the security
Rm= expected market reutrn
(Rm - Rf)= equity market premium
BETA
It measures a stock's relative volatility

M
2
  Cov i, M
Cov = covariance between a stock and the market
i, M

 = variance of the market

M
 Computing Portfolio Beta
• A simple weighted average of the beta of each individual asset
in the portfolio, where weights represent the proportion of
investment in each asset in the portfolio

• p = (w1× 1) + (w2× 2) + … +(wn× n)

n
p =  w i i
i=1
• Where wi represents proportion of total investment in
security i and I represents beta of security i in the portfolio
• Security Market Line: linear risk-return trade-off for
all individual stocks.

E(R)

Rf b=1

Systematic Risk

The SML graphs the results from the capital asset pricing model

(CAPM) formula. The x-axis represents the risk (beta), and the y-axis
represents the expected return. The market risk premium is
determined from the slope of the SML.
 Arbitrage Pricing Theory
• APT is an alternative to CAPM.
• APT requires fewer assumptions and
considers multiple factors to explain the risk
of an asset, in contrast to single-factor CAPM,
which just uses the market return.

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• APT assumes:
1.Perfect competition in capital markets
2.More wealth is always preferable to less
wealth
3.A multiple factor model represents the
random process by which asset returns are
generated.

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 BUT….
APT can not explain the differences in
returns for various securities because the
model does not specify which factors
impact security returns.

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 Unsystematic Risk
•Unsystematic Risk is sometimes referred to as "specific
risk". This kind of risk affects a very small number of assets.
•An example is news that affects a specific stock such as a
sudden strike by employees. Diversification is the only way to
protect yourself from unsystematic risk.
•The rationale behind this technique contends that a portfolio
of different kinds of investments will, on average, yield higher
returns and pose a lower risk than any individual investment
found within the portfolio.
•The benefits of diversification will hold only if the securities in
the portfolio are not perfectly correlated.
 The Efficient Frontier
• For every level of return, there is one portfolio that offers the
lowest possible risk, and for every level of risk, there is a portfolio
that offers the highest return. These combinations can be plotted
on a graph, and the resulting line is the efficient frontier.

• Figure shows the efficient frontier

for just two stocks - a high risk/high
return technology stock (Google)
and a low risk/low return consumer
products stock (Coca Cola)
• Any portfolio that lies on the upper part of the curve is
efficient: it gives the maximum expected return for a given level
of risk. A rational investor will only ever hold a portfolio that
lies somewhere on the efficient frontier. The maximum level of
risk that the investor will take on determines the position of the
portfolio on the line.

•If you were to borrow to acquire a risk-free stock, then the

remaining stock portfolio could have a riskier profile and,
therefore, a higher return than you might otherwise choose