Where does systematic risk collide?

The part of an asset's risk that comes from moving with the whole market and cannot be removed by diversifying, as opposed to the idiosyncratic risk that a large portfolio cancels out. In the Capital Asset Pricing Model of Sharpe (1964) and Lintner (1965), an investor is rewarded only for bearing this market-wide risk, and its size for a given asset is measured by beta, the sensitivity of the asset's return to the return on the market. The idea rests on Markowitz's (1952) portfolio theory, which showed that combining assets washes out the risk specific to each one and leaves only the risk they share. So the referent is a property of a single asset priced inside a model of a whole market: how far its return swings with the market, in units of beta. It is not the risk that the market itself, or the wider financial system, falls apart.[1][2][3]

Unit

An asset's sensitivity to market-wide moves, stated as beta

Recovery means

Not applicable

Measured by

Estimated by regressing an asset's returns on market returns; the slope is beta, and the model prices only that exposure

The finding that beta, on its own, does a poor job of explaining which stocks earn higher average returns, which pushed the field toward models with more than one risk factor. Fama and French (1992) sorted stocks over several decades and reported that the flat link between beta and return largely disappeared once size and book-to-market value were accounted for, while those two variables predicted returns strongly. This did not show that systematic risk is meaningless, but it did challenge the claim that a single market beta captures all the priced risk in an asset. The response was a family of multifactor models, in which returns load on several sources of shared risk rather than one. So the construct here is still an asset's exposure to undiversifiable risk, now spread across factors, and the standing of the original single-beta version is contested.[4]

Unit

An asset's loadings on several common risk factors

Recovery means

Not applicable

Measured by

Portfolios sorted on size and book-to-market; returns regressed on market, size, and value factors

The risk that a whole financial system, rather than one asset, breaks down, through contagion, the failure of firms too big or too connected to fail, and fire sales that pass losses from one institution to the next. Acharya, Pedersen, Philippon, and Richardson (2017) proposed measuring a bank's contribution to this risk as its expected capital shortfall when the system as a whole is in crisis. Note the spelling: this is systemic risk, the risk of system-wide collapse, and it is a different construct from the systematic risk of asset pricing, which is one asset's undiversifiable exposure to market moves. The two words sit one letter apart and both name risk that holding many things cannot escape, but a bank can carry low systematic risk and still be a large source of systemic risk. The referent is a property of the financial system, and of each institution's part in its fragility, not a coefficient in a pricing model.[5]

Unit

A firm's contribution to system-wide collapse, such as its expected shortfall in a crisis

Recovery means

Not applicable

Measured by

Estimated by a firm's expected capital shortfall in a market-wide crisis (SES or SRISK), or by co-risk measures such as CoVaR