Dual Exposure: Systematic and Systemic Risk

Systemic risk can be measured by the covariance between an institution’s return and the sector return. This allows systemic risk to be decomposed by decomposing the sector return. When the sector return is separated into a market-driven component and a market-orthogonal residual, systemic risk splits into systematic risk, reflecting exposure to the market-driven component, and net systemic risk, reflecting exposure to the residual. We examine how these two risk dimensions relate to financial sector returns, contemporaneously and intertemporally. Using a sample including the 2008 global financial crisis, we find that including both risks explains substantial variation in financial sector returns.