Unsystematic Risk

Anna knows more about systematic risk of winfit, also called general market risk. However, she wants to understand both risks before buying winfits stocks. Hence, she is wondering about the meaning of winfits unsystematic risk.

Unsystematic risk describes an industry or company specific risk that is part of each investment. This risk concerns a specific company and is therefore also called “specific or risidual risk”.

In contrast to systematic risk, diversification (buying different assets in different industries) can reduce unsystematic risk.

A unsystematic risk for winfit is the increase of the price for cotton, since most of their sports clothes are made out of this material. If the cotton price increases, winfits profit margin decreases. In order to minimize this risk, Anna could also buy commodities (like cotton).

This diversification reduces the unsystematic risk, but not the systematic risk. While looking at the overall risk of an investment, the major parts are specific, unsystematic risks while a smaller portion includes the systematic risk.

Typical examples for unsystematic risk include new competitors, new law regulations or the price increase of raw materials.   

Systematic Risk

As you know from this article, Anna loves sports. Meanwhile, she did some market research and finally decided to buy 3 stocks of winfit. Winfit is a publicly listed company which sells all kind of sports equipment. Anna’s winfit favourite is the wearable smartwatch with an heart rate tracker. If you wonder why companies are publicly listed, check out this article.   

While Anna did her research, she stumbled upon the terms systematic risk and found the following definition:

Systematic Risk is the general market risk. This systematic risk concerns the entire market and since it can’t be reduced by buying different stocks, this risk is also called “non-diversifiable risk”.

Everyone who invests in the market, assumes this general market risk. Systematic risk is caused by events, that influence the entire market such as wars, major political decisions or natural disasters. In the week after hurricane Irma hit Florida, the S&P 500 fell almost 2%. S&P 500 represents 500 large companies that are listed on the American Stock markets.

Anna asked herself “Does winfit really have the same systematic market risk as any other company? For example when Irma hits Florida, winfit might not be affected as much as insurance companies?”

And Anna was right. Only very few companies have the exact same systematic risk as the market does.

Beta measures the amount of systematic risk in an investment. It’s a measure for correlation between investment and market.

A Beta > 1 means that an investment has more systematic risk than the market.

A Beta < 1 means that an investment has less systematic risk than the market.

A Beta = 0 means that an investment has the same systematic risk as the market.

As previously mentioned, the term market refers to indices like S&P 500, DAX or Russell 2000. Continue reading, if you’d like to learn more about unsystematic risk.

Investment #7 – Call Options

Katie loves Este Lauder (EL) products and thinks that the price of EL shares will go up. Marissa currently owns EL shares, but thinks that the price will either stay the same or go down in the future. The girls talk, and decide to write up a call option.

Call Option

An agreement that gives an investor the right, but not the obligation, to buy an asset at a specified price within a specific time period.

Right now, each EL share is priced at 10$. Marissa writes up a call option agreeing to give Katie 100 shares of EL at 12$ per share in a month. The fee that Katie pays for the option (aka premium), is 200$ (the 2$ per stock difference times 100 shares).

If the price of EL shares shoots up to 15$ in a month, Katie can exercise the option and buy Marissa’s 100 shares of EL at only 12$. Since Katie is getting the shares for 3$ less than the actual price, she makes $300 (3$ x 100 shares) minus the initial fee of $200, resulting in a net profit of $100.

If the price of EL shares go down to 8$, Katie will not chose to exercise the option (she won’t buy the 100 shares), and will simply loses the $200 initial fee she paid at the start.

Call options allow individuals to speculate about stocks that they do not own. If you believe a certain company or asset will go up in the future, you might want to consider a call option!

Investment #6 – Futures Contracts

Lily is the owner of a coffee shop. Every month, Lily buys raw coffee beans from Emma’s farm for 2$ per bag. Both girls are happy with this price, and decide to write up a futures contracts to protect themselves from price changes.

 

Futures Contract

A contract for assets (especially commodities or shares) bought at agreed prices but delivered and paid for later.

 

To sign a futures contract, both Lily and Emma meet with an investor separately, and the investor handles the transaction. Lily signs a contract stating that she will purchase the coffee at 2$/bag in the future, and Emma signs a contract stating that she will sell her coffee at 2$/bag in the future. Any changes in price will be dealt by the investor.

These contracts protect both Lily and Emma from the risk of volatile price changes:

For example, if the coffee market becomes more competitive, the price of coffee will drop, and Emma will be forced to sell her coffee bags at a cheaper rate thus losing money.

On the other hand, if poor weather affects the coffee crops, the price of coffee will increase, and Lily will have to pay more for her bags of coffee.

Thus, by having a future contract in place, the “risk of the unknown” goes away, and both girls know exactly what to expect in the future. They can continue their business operations without worry.

So what does the investor have to do with all this?

Well, if the price of coffee goes under 2$ per bag, the investor promises to pay Emma the difference so that she doesn’t lose any money. However, if the price goes over 2$ per bag, the investor gets to keep the extra profits from Emma’s sales.

On the other hand, if the price goes down, Lily will still pay the investor 2$ per bag and the investor will profit from the difference. If the price goes up, the investor will cover the difference and Lily will still pay only 2$.

Of course, there is potential for an upside or downside for both Lily, Emma and the investor when signing a futures contract. However, both girls get to benefit from ditching the “risk of the unknown”.