Is systemic risk systematic? Evidence from the U.S. stock markets

• Author: Seo Joon Choi,Kanghyun Kim,Sunyoung Park
• Published date: 01 October 2020
• Date: 01 October 2020
• DOI: http://doi.org/10.1002/ijfe.1772

RESEARCH ARTICLE

Is systemic risk systematic? Evidence from the U.S. stock

markets

Seo Joon Choi

1

| Kanghyun Kim

1

| Sunyoung Park

2

1

Defense Financial Analysis Group, Korea

Institute for Defense Analyses (KIDA),

Seoul, South Korea

2

Fund & Pension Division, Korea Capital

Market Institute (KCMI), Seoul, South

Korea

Correspondence

Sunyoung Park.

Email: sunyoung.park@kcmi.re.kr

Funding information

National Research Foundation of Korea,

Grant/Award Number: NRF-

2013R1A1A1076066

Abstract

The distinction between the role of systemic risk and the systematic risk

remains unclear and is sometimes confusing. In this paper, we exploit three

types of systemic risk measurements and examine their role as a systematic

risk component in the equity market. We first construct the systemic risk fac-

tors by using the portfolio mimicking method. Then we analyse the systemic

risk factors through the lens of the empirical asset pricing test to determine

whether the factors are systematically priced in the equity market. As a result,

we empirically find evidence that the systemic risk factors are systematically

priced in the equity market, indicating that the systemic risk is compensated

for the higher returns.

KEYWORDS

Empirical asset pricing model, equity market, factor model, systematic risk, systemic risk

1|INTRODUCTION

Ever since the global financial crisis occurred in 2007,

measuring and accounting the systemic risk has been an

important issue for regulators and even investors.

Although Hansen (2013) points out the lack of means to

define the systemic risk, the systemic risk is broadly

known as the risk that causes the financial system dys-

function starting from individual group or components to

eventually entire economy such as the risk was amplified

during the 2007 Global Financial Crisis.

1

Contrary to sys-

temic risk, the studies on systematic risk have been well

conceptualized within the work of Sharpe (1964). By defi-

nition, systematic risk is the aggregate risk that funda-

mentally priced over the entire market (such as stock

market) that cannot be eliminated by diversification. In

other words, if investors are exposed to this risk, then

they need to be compensated with the expected return.

By definitions, the systemic risk and the systematic risk

seem to be independent to each other, and affect the mar-

kets in different prospective.

Specifically, we analyse the relation between system-

atic risk and systemic risk in light of the work conducted

by Hansen (2013). Particularly, he demonstrates that

macroeconomic policies and the consequences may be

the sources of systematic risk. As the definition of the sys-

temic risk indirectly indicates the risk that consequently

affects the overall economy or financial markets, govern-

ments' attempts to reduce the risk

2

could be another

source of a systematic risk component. In other words,

these two independent risks may be interacted each

other, and moreover the systemic risk would be a one of

the sources of the systematic risk. On the basis of

Hansen's work, we hypothesize that systemic risk itself

also could be a component of systematic risk. In our

research, we focus on testing the systemic risk as if it

plays the role as the systematic risk component in the

equity markets.

Seo Joon Choi (chltjwns1@kida.re.kr), is an associate research fellow in

Korea Institute for Defence Analyses (KIDA), KoreaKanghyun Kim

(kkh203@kida.re.kr), is a researcher in Korea Institute for Defence

Analyses (KIDA), KoreaSunyoung Park (sunyoung.park@kcmi.re.kr),

corresponding author, is a research fellow in Korea Capital Market

Institute (KCMI), Korea

Received: 4 December 2017 Revised: 9 March 2019 Accepted: 13 September 2019

DOI: 10.1002/ijfe.1772

Int J Fin Econ. 2020;1–22. wileyonlinelibrary.com/journal/ijfe © 2020 John Wiley & Sons, Ltd. 1

642 © 2020 John Wiley & Sons, Ltd. Int J Fin Econ. 2020;25:642–663.wileyonlinelibrary.com/journal/ijfe

Accordingly, our research investigates the relation-

ship between systemic risk and systematic risk. In

order to test the role of systemic risk as a systematic

risk component, we first exploit three measures of exis-

ting systemic risk that are selected according to five

criteria among various measures. Then, the most

importantly, we use the portfolio mimicking technique

to extract our novel systemic risk factors from the U.S.

equity markets. Lastly, we discover whether the sys-

temic risk factors are systematically priced in the

equity market through the lens of empirical asset pric-

ing tests. Consequently, our results shed light on the

relationship between systemic risk and systematic risk,

further highlighting the role of systemic risk as another

source of systematic risk component.

In detail, our first main task is to identify the possible

and appropriate systemic risk measures for our research.

Since the systemic risk has several distinct definitions

that are not definitive, the systemic risk measures use dif-

ferent aspects or indicators to capture the systemic risk.

3

In order to choose the appropriate systemic risk mea-

sures, we use five criteria: aggregate level of systemic risk

measure,

4

appropriate data period (around 25 years), the

frequency of the measure (at least monthly data fre-

quency), data accessibility, and availability of the mea-

sures

5

to construct mimicking factors. Through the five

criteria, we finalize the list of three systemic risk mea-

sures that are appropriate to use for the further research:

the Financial Turbulence Index (FTI) from Kritzman and

Li (2010); the absorption ratio (AR) from Kritzman et al.

(2011); and the global M1 gap from Alessi and Detken

(2009).

6

Then, with the chosen systemic risk measures,

we mimic portfolios of the systemic risk measures to con-

struct the new risk factors from the U.S. equity markets

with a sample period from July 1989 to December 2014.

The descriptive statistics show that the new systemic risk

factors have averages of positive values over the sample

period, indicating that the positive risk premium can be

achieved by taking the systemic risk in the equity market.

With the novel systemic risk factors using portfolio

mimicking method, we conduct the empirical asset pric-

ing tests to discover whether the systemic risk factor is

systematically priced in the U.S. equity markets. After we

analyse the redundancy of systemic risk factors with exis-

ting risk factors, we compare the performance of the

Fama–French 5-factor model with that of our new factor

models (containing each systemic risk factor with the

Fama–French 5-factor model) to find the relation

between systemic and systematic risk. To compare, we

exploit the diverse LHS testing portfolios to represent the

cross-section variation of the equity market excess

returns: 25 left-hand-sided (LHS) testing portfolios with

the criteria of systemic riskiness and size, and the original

LHS testing portfolios with the criteria of two aspects

excluding systemic riskiness.

As a result, our empirical analysis indicates that all

three systemic risk factors systematically capture the

average returns of portfolios formed on size and systemic

riskiness. Specifically, the beta coefficients of new sys-

temic risk factors are more statistically significant than

the value factor, and the descriptive statistics of the inter-

cepts indicates that excess returns are better explained

when the new factor model is used. Moreover, we pro-

ceed to test our model in different types of LHS testing

portfolios that are not constructed using systemic riski-

ness. The results are robust that the systemic risk factors

increase the model performances to explain the excess

returns of the equity markets. We also execute the same

analysis with two split sample-periods based on the

global financial crisis in 2007. The empirical results sug-

gest that the systemic risk factor are systematically priced

in the equity market for both before and after the crisis.

Particularly, the role of the systemic risk as the system-

atic risk component are significantly enhanced after the

crisis, implying the structure of the equity market risk

changed in terms of systemic risk in the incident of the

crisis. To sum, we discover the relationship between the

systemic risk and systematic risk: the systemic risk is the

new source of the systematic risk component. The sys-

temic risks captured by FTI, AR, and the global M1 gap

are systematically priced in the U.S. equity markets, indi-

cating that the systemic risk cannot be eliminated by the

diversification; the market compensates risk premium for

the systemic risk.

The rest of the paper is organized as follows: Section

2 reports literature review for the research. Section 3 pre-

sents the data source and methodologies of systemic risk

measures. Section 4 demonstrates the construction of the

systemic risk factor and mimicking portfolios. Section 5

analyzes the empirical test and results. Finally, section 6

contains the conclusion.

2|LITERATURE REVIEW

Hansen (2013) mentions that the source of the systematic

risk can include the shocks induced by macroeconomic

policies. Considering that systemic risk is controlled by

not only macroprudential policies but also monetary and

fiscal policies (Caruana, 2010), this concept further sug-

gests that the systemic risk and its consequences (macro-

economic policies) can be a new possible source of

systematic risk. Along with the importance of studying

the relationship between the systemic risk and systematic

risk, Giesecke and Kim (2011) note that measuring the

risk premium from systemic risk is one of the future

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