In finance and more, what is systemic risk is exposure to events that affect aggregate outcome including market wide asset holdings, national total resource holdings, or the aggregate income of a country. The impact of these events on the financial system is known as systemic risk. It is also known as the risk that will affect future prices or the interest rates. The prices or interest rates will depend on how the event affected by the event will affect different parts of the financial system. This means that in order to determine the impact of the event, one needs to have knowledge on how the entire financial system works.
In other words, it is not possible for any one individual to evaluate the risk of systemic risks. These risks cannot be assessed by looking at isolated events. The events must be analyzed systematically and looked at as if they affect the whole system. The purpose of this article is to explore the meaning of systemic risk and its implications on investment strategies.
The first definition of systemic risk introduced in economics is “the probability of an increase in the level of output that will exceed the rate of inflation”. It can also be said as “the tendency for price rises or falls in the same direction to occur simultaneously or coincidentally with increases or decreases in the level of output”. Since the events affects the whole business cycle, it may result to systemic changes in the structure of the economy or may bring down the overall performance of the economy.
Now, in order to understand what is systemic risk, one must be able to specify what it is. Simply put, the occurrence of systematic fluctuations that affect the prices of underlying assets over time is called systemic risk. Therefore, any change in the structure of the economy can bring down the performance of the economy. This means that any change that changes the probability of distribution of risk is systemic risk.
Basically, a change in the probability distribution of risk can bring down the value of the asset, increase the uncertainty of the value of an asset or both. These changes can bring about systemic changes, which are very dangerous for the economy, especially when the economic activities are considered as primary drivers of the structure of the economy. Therefore, any event that modifies the normal distribution of risks is called systemic risk.
There are three types of systemic risks that have a major influence on the market operations. They are credit risk, business risk and financial risk. Credit risk refers to the chance that one company’s financing will be rejected. On the other hand, business risk refers to the possibility that a borrower will lose his resources in a particular business venture. Financial risk refers to the possibility that the resources of a borrower will be used for non-productive purposes such as gambling.
Systemic risk can have severe effects on the financial system. When the prices of key assets decrease, so too does the share value of the corresponding company. The effects of this negative volatility may even lead to a catastrophic decline in the market value of the economy. The key to preventing systemic risks from hurting the economy is to identify them early. It is important for managers to develop an overall risk management strategy that combines subjective and objective risk management techniques.
Managers should first define the parameters of the risk management strategy that they intend to use before carrying out the methodical analysis of potential systemic risks. Once the risk characteristics are determined, the managers can make use of a range of objective as well as subjective techniques to identify and evaluate potential sources of variability. The manager can also make use of both the quantitative and the qualitative methods for assessing systematic risks. Systematic risk analysis can bring forth a number of useful tools for managers to strengthen their capacity to control and mitigate the risks. This form of risk management can help managers to identify areas that require attention and can help in identifying areas that require attention but that do not require systemic risk controls. In the end, what is systematic risk analysis is simply a way of looking into the system and attempting to understand it better.