Which statement best describes the distinction between systemic risk and idiosyncratic risk?

Which statement best describes the distinction between systemic risk and idiosyncratic risk?

• A. Systemic risk refers to the risk that a single institution's failure triggers widespread disruption; idiosyncratic risk affects only specific assets.
• B. Systemic risk is diversifiable; idiosyncratic risk is not.
• C. Systemic risk applies only to governments.
• D. Idiosyncratic risk affects the whole economy.

Answer: (A)

Systemic risk is the risk that trouble at one part of the financial system can cascade through interconnected markets and institutions, causing broad disruption across the system or economy. Because these linkages mean many assets and players are exposed to the same shock, systemic risk cannot be eliminated just by holding more assets; it’s non-diversifiable. Idiosyncratic risk, on the other hand, is tied to a specific asset or firm. It stems from factors unique to that asset or company, and because these factors don’t move with the entire market, they can be largely mitigated by diversification. The described statement captures this distinction: systemic risk arises when a single institution’s failure can trigger widespread disruption, while idiosyncratic risk affects only particular assets. The other options misstate who is affected or whether the risk is diversifiable.

Systemic risk is the risk that trouble at one part of the financial system can cascade through interconnected markets and institutions, causing broad disruption across the system or economy. Because these linkages mean many assets and players are exposed to the same shock, systemic risk cannot be eliminated just by holding more assets; it’s non-diversifiable.

Idiosyncratic risk, on the other hand, is tied to a specific asset or firm. It stems from factors unique to that asset or company, and because these factors don’t move with the entire market, they can be largely mitigated by diversification.

The described statement captures this distinction: systemic risk arises when a single institution’s failure can trigger widespread disruption, while idiosyncratic risk affects only particular assets. The other options misstate who is affected or whether the risk is diversifiable.