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How systemic risk spreads through a financial system?

Answer by Scott Hoover:

I'm not sure that "spreads" is the most accurate description of how systematic risk affects the market. It is more about simultaneous impact than it is about something that gets propagates through the market. Consider the risk associated with higher inflation and suppose that the Chairman of the U.S. Federal Reserve makes public comments suggesting that higher inflation is imminent. Higher inflation triggers higher interest rates, which in turn are bad for most stocks. Because of this, the Chairman's comments cause investors to be less likely to buy stocks and more likely to buy other investments that are less negatively impacted by higher inflation. The result is net selling in the stock market and net buying in some other markets. Thus, the stock market would tend to drop in the aftermath of the Chairman's comments.

One interesting aspect of systematic risk is that it affects different assets in different ways. News of higher inflation would be good news for companies that benefit from higher interest rates, so stock in those companies might increase value. This basic idea that different assets have different sensitivities to market risk is at the core of the well-known Capital Asset Pricing Model (CAPM). Although the applicability of the CAPM to real-world situations is a matter of debate, the intuition behind it is sound. Those interested in learning more about systematic risk should begin by exploring the CAPM.

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