Systematic risks

The exam builds most of its systematic-risk questions around a small set of named risks. Learn what each one is, why it cannot be diversified away, and how it differs from the unsystematic risks covered in the next lesson.

What Is Systematic Risk?

• Systematic risk is the risk that broad market or economic factors cause the value of investments to decline regardless of individual company performance
• Also called market risk or non-diversifiable risk
• Affects the entire market or large segments of it simultaneously
• Cannot be eliminated through diversification; only hedging or asset allocation can mitigate it
• Measured by beta (beta of 1.0 = moves with the market; beta > 1.0 = more volatile than the market)

Exam Tip: Gotchas

Systematic risk cannot be diversified away. The exam tests whether you know the difference between risks that diversification eliminates (unsystematic, next lesson) and risks that persist no matter how many securities you hold (systematic). Interest rate risk and inflation risk are systematic because they affect the entire bond market, not just one issuer.

Why Does Interest Rate Risk Move Bond Prices?

Interest rate risk is the risk that changes in interest rates reduce the value of fixed-income investments.

• Inverse relationship: when interest rates rise, bond prices fall, and vice versa
• Affects all fixed-income securities regardless of credit quality
• Longer maturity and lower coupon mean greater sensitivity to interest rate changes

Imagine you own a bond paying 5% interest. If new bonds start paying 7%, nobody wants your 5% bond at full price, so you would have to sell it at a discount. That is why rising rates push bond prices down. A diversified portfolio of bonds does not avoid this, since all bonds decline together when rates rise.

Exam Tip: Gotchas

Longer maturity plus lower coupon means the greatest interest rate sensitivity. The exam frequently asks which of two bonds is more sensitive to a rate change. Choose the one with the longer maturity, and if maturities match, the one with the lower coupon.

Rate changes can pressure equities too, not just bonds. Highly leveraged sectors such as utilities and real estate see their stock prices move with rates for a different reason, covered under Sector Risk below.

What Is Market Risk?

Market risk is the risk that the overall stock market declines, dragging down most securities regardless of individual merit.

• Represents broad market movements that affect virtually all stocks simultaneously
• Cannot be eliminated through diversification

How Does Inflation Erode Returns?

Inflation risk (purchasing power risk) is the risk that rising prices erode the real return on investments.

• Also called purchasing power risk
• Fixed-income securities are most vulnerable because their payments are fixed in nominal terms
• Example: if a bond pays 4% but inflation is 5%, the real return is negative 1%

What Happens When Currency Values Shift?

Exchange rate risk (currency risk) is the risk that changes in foreign currency exchange rates reduce the value of international investments when converted back to domestic currency.

• Also called currency risk
• Applies to any investment denominated in a foreign currency, including foreign stocks, bonds, and real estate
• Example: you buy a European stock that rises 10% in euros, but the euro falls 15% against the dollar, so your U.S. dollar return is negative
• Cannot be eliminated through diversification across multiple foreign investments if the U.S. dollar strengthens broadly

Why Is Sector Risk Systematic Rather Than Company-Specific?

Sector risk is the risk that an entire industry or economic sector declines due to macroeconomic conditions.

• Affects all companies within the same industry, regardless of individual company quality
• Examples: an energy sector decline from falling oil prices, or a real estate and utilities sector decline from rising rates
• Cannot be eliminated by diversifying within a sector; owning five different bank stocks still leaves full exposure to sector risk

Highly leveraged, capital-intensive industries feel rate changes the most. Real estate and utilities both finance most of their assets with debt, such as properties and power plants, so rising rates directly raise their borrowing costs and squeeze margins, pressuring the whole sector's stock prices at once, not just its bonds.

A single regulatory change, commodity price shock, or rate change can sweep through an entire industry simultaneously, just as a market crash sweeps through all stocks. That breadth is why sector risk is systematic: it affects a broad swath of securities beyond any one company.

Exam Tip: Gotchas

Utility stocks decline when interest rates rise, but not because utilities are fixed-income securities. Utilities are one of the most highly leveraged industries, so rising rates raise their borrowing costs directly. The mechanism tested here is sector risk acting through leverage, separate from the bond-price interest rate risk covered above.

Can Geopolitical Events Be Diversified Away?

Geopolitical risk is the risk that wars, political instability, sanctions, trade disputes, or changes in international relations cause broad market declines.

• Can affect broad markets, such as a war between major powers, or specific regions and countries
• Cannot be eliminated through diversification if the event affects the entire market or multiple markets simultaneously

Major geopolitical events can cause widespread market declines that affect many asset classes and countries at once, regardless of individual security fundamentals. That breadth, not any single company's exposure, is what makes the risk systematic.

What Is Reinvestment Risk?

Reinvestment risk is the risk that cash flows, such as coupons and principal, must be reinvested at lower prevailing rates when interest rates fall.

• When a bond matures or pays a coupon during a period of declining rates, the investor may not be able to earn the same return on the reinvested funds

Memory Aid: PRIME captures the five systematic risk types most commonly tested: Purchasing power (inflation), Reinvestment, Interest rate, Market, Exchange rate (currency).

What Should You Check on Exam Day?

• Can you name all seven systematic risks and explain why each cannot be diversified away?
• Do you know that NASAA's outline specifically names interest rate, sector, and geopolitical risk?
• Can you identify which of two bonds is more interest-rate sensitive from maturity and coupon alone?
• Do you know why utility and real estate stocks fall when rates rise, and that the mechanism is sector risk through leverage, not fixed-income exposure?
• Can you recite the PRIME mnemonic on demand: purchasing power, reinvestment, interest rate, market, exchange rate?