Explain the difference between systemic risk and idiosyncratic risk.

Explain the difference between systemic risk and idiosyncratic risk.

• A. Systemic risk affects a single institution; idiosyncratic affects the entire system
• B. Systemic risk affects the entire financial system; idiosyncratic affects a single institution or asset and can be diversified away
• C. Systemic risk can be diversified away; idiosyncratic cannot
• D. Systemic risk relates to credit risk; idiosyncratic to liquidity

Answer: (B)

Systemic risk is the risk that touches the entire financial system or market, arising from factors that affect many institutions and assets at once—think broad macro shocks, widespread liquidity squeezes, or a market-wide crisis. Idiosyncratic risk, by contrast, is specific to a single firm or asset and comes from company- or asset-level factors, like a product failure or a default event. Because the latter is tied to one entity or asset, it can be reduced by diversification across many different investments. The former cannot be eliminated through diversification since it moves together with the whole system. That’s why the statement that systemic risk affects the entire financial system and idiosyncratic risk affects a single institution or asset and can be diversified away is the best description. The other choices either misstate who is affected or whether diversification can reduce the risk, and they don’t capture the essential distinction.

Systemic risk is the risk that touches the entire financial system or market, arising from factors that affect many institutions and assets at once—think broad macro shocks, widespread liquidity squeezes, or a market-wide crisis. Idiosyncratic risk, by contrast, is specific to a single firm or asset and comes from company- or asset-level factors, like a product failure or a default event. Because the latter is tied to one entity or asset, it can be reduced by diversification across many different investments. The former cannot be eliminated through diversification since it moves together with the whole system. That’s why the statement that systemic risk affects the entire financial system and idiosyncratic risk affects a single institution or asset and can be diversified away is the best description. The other choices either misstate who is affected or whether diversification can reduce the risk, and they don’t capture the essential distinction.