What is Systemic Risk?
Systemic risk is the risk that the entire financial market will collapse, this is the opposite of risk being linked to any specific individual entity, group or component of a system. Systemic risk is a constant problem even when dealing with a portfolio which is very well-diversified. It is the risk that changes in the financial system can possibly result in a failure or breakdown of this system and trigger major damages to the real economy. Such changes can come from the failure of large and interconnected institutions, from endogenous imbalances that add up over time, or from a sizable unexpected event. Systemic risk can be triggered by a number of things such as stock market crashes, interest rate hikes, a country not being able to pay off its debts, a subprime mortgage crisis, or any event that causes massive panic selling. It is a permanent risk that the financial markets will crash just like they did in late 2008 and early 2009. Systemic risk has been compared with a bank run which has a domino effect on all the other banks who were involved and due to be paid off by the original bank. The consequences are huge such as a surge in unemployment and a huge increase in public debt.How would I define systemic risk? In my understanding of systemic risk, I would say it is a risk that cannot be got rid of by diversifying. Portfolio theory allows you to diversify risk. Systemic risk is a threat to all instruments, strategies and asset classes. It is not possible to avoid systemic risk through diversification.
What is Hedging?Hedging is used to reduce any major losses/gains suffered by an individual or a company. While you cannot hedge out systemic risk entirely, there is something extremely important that one can do to cover themselves as best as possible. When a person chooses to hedge, they are insuring themselves against a negative event. This doesn't stop the negative event altogether from occurring, but if it does happen and you're...
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