Systemic risk exists because a) financial institutions borrow using long-term debt securities...

Question:

Systemic risk exists because

a) financial institutions borrow using long-term debt securities but lend their funds for short-term periods.

b) financial institutions invest heavily in Treasury securities and therefore are exposed to the possibility that the government will default on its debts.

c) financial institutions invest in similar securities and therefore are similarly exposed to large declines in prices of those securities.

d) there is no government regulation of financial markets.

Types of Risks:

Riks can be classified based on whether such risks are diversifiable or not. Diversifiable risks are those risks that are unique to a particular firm and they can be reduced since they are under the control of the management. These risks are also called unsystematic risks. On the other hand, undiversifiable risks refer to the risks that cannot be reduced.

Answer and Explanation:

The correct answer is (c) financial institutions invest in similar securities and therefore are similarly exposed to large declines in prices of those securities.

Systematic risks refer to the risk that faces the whole industry, unlike unsystematic risk that is unique to a particular firm. A price decline will affect all the firms in an industry and therefore, the price decline is an example of systematic risk. In other words, systematic risk cannot be controlled by a firm. The price decline is out of control of the firm therefore, systematic risks will exist especially when there is price decline.


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Investment Risks: Definition & Types

from Finance 305: Risk Management

Chapter 3 / Lesson 3
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