Evaluation of Customers - Types of Investment Risks

Interest Rate Risk
Interest rate risk is the possibility that a fixed-rate debt instrument will decline in value as a result of a rise in interest rates. Whenever investors buy securities that offer a fixed rate of return, they are exposing themselves to interest rate risk. This is true for bonds and also for preferred stocks.

The following article, Forces Behind Interest Rates, will deepen your understanding of the importance of interest rates and what makes them change.

Furthermore, understand the various factors that influence interest rates, so that you can learn to anticipate their movements for your benefit in the article, Trying to Predict Interest Rates.

Business Risk
Business risk is the measure of risk associated with a particular security. It is also known as unsystematic risk and refers to the risk associated with a specific issuer of a security. Generally speaking, all businesses in the same industry have similar types of business risk. But used more specifically, business risk refers to the possibility that the issuer of a stock or a bond may go bankrupt or be unable to pay the interest or principal in the case of bonds. A common way to avoid unsystematic risk is to diversify - that is, to buy mutual funds, which hold the securities of many different companies.

Credit Risk
This refers to the possibility that a particular bond issuer will not be able to make expected interest rate payments and/or principal repayment. Typically, the higher the credit risk, the higher the interest rate on the bond.

Taxability Risk
This applies to municipal bond offerings, and refers to the risk that a security that was issued with tax-exempt status could potentially lose that status prior to maturity. Since municipal bonds carry a lower interest rate than fully taxable bonds, the bond holders would end up with a lower after-tax yield than originally planned.

Call Risk
Call risk is specific to bond issues and refers to the possibility that a debt security will be called prior to maturity. Call risk usually goes hand in hand with reinvestment risk, discussed below, because the bondholder must find an investment that provides the same level of income for equal risk. Call risk is most prevalent when interest rates are falling, as companies trying to save money will usually redeem bond issues with higher coupons and replace them on the bond market with issues with lower interest rates. In a declining interest rate environment, the investor is usually forced to take on more risk in order to replace the same income stream.

Inflationary Risk
Also known as purchasing power risk, inflationary risk is the chance that the value of an asset or income will be eroded as inflation shrinks the value of a country's currency. Put another way, it is the risk that future inflation will cause the purchasing power of cash flow from an investment to decline. The best way to fight this type of risk is through appreciable investments, such as stocks or convertible bonds, which have a growth component that stays ahead of inflation over the long term.

Liquidity Risk
Liquidity risk refers to the possibility that an investor may not be able to buy or sell an investment as and when desired or in sufficient quantities because opportunities are limited. A good example of liquidity risk is selling real estate. In most cases, it will be difficult to sell a property at any given moment should the need arise, unlike government securities or blue chip stocks.

Market Risk
Market risk, also called systematic risk, is a risk that will affect all securities in the same manner. In other words, it is caused by some factor that cannot be controlled by diversification. This is an important point to consider when you are recommending mutual funds, which are appealing to investors in large part because they are a quick way to diversify. You must always ask yourself what kind of diversification your client needs.

Reinvestment Risk
In a declining interest rate environment, bondholders who have bonds coming due or being called face the difficult task of investing the proceeds in bond issues with equal or greater interest rates than the redeemed bonds. As a result, they are often forced to purchase securities that do not provide the same level of income, unless they take on more credit or market risk and buy bonds with lower credit ratings. This situation is known as reinvestment risk: it is the risk that falling interest rates will lead to a decline in cash flow from an investment when its principal and interest payments are reinvested at lower rates.

Social/Political / legislative  Risk
Risk associated with the possibility of nationalization, unfavorable government action or social changes resulting in a loss of value is called social or political risk. Because the U.S. Congress has the power to change laws affecting securities, any ruling that results in adverse consequences is also known as legislative risk.

Currency/Exchange Rate Risk
Currency or exchange rate risk is a form of risk that arises from the change in price of one currency against another. The constant fluctuations in the foreign currency in which an investment is denominated vis-à-vis one's home currency may add risk to the value of a security.

American investors will need to convert any profits from foreign assets into U.S. dollars. If the dollar is strong, the value of a foreign stock or bond purchased on a foreign exchange will decline. This risk is particularly augmented if the currency of one particular country drops significantly and all of one's investments are in that country's foreign assets. If the dollar is weak, however, the value of the American investor's foreign assets will rise.

Understandably, currency risk is greater for shorter term investments, which do not have time to level off like longer term foreign investments.

Exam Tips and Tricks
Know the types of risks associated with investments! If you understand the fundamental concepts behind each type of risk, you will be able to make investment recommendations to your clients with great confidence.

Concept of Risk vs. Reward
Related Articles
  1. Investing Basics

    How To Handle A Serious Dispute With Your Broker

    Find out what to do if you have a dispute with your broker.
  2. Professionals

    Hedge Funds and the Law

    Learn how hedge funds have gotten in trouble for illegal insider trading. Read about questionable high-frequency trading (HFT) strategies.
  3. Professionals

    Career Advice: Financial Analyst Vs. Investment Banker

    Read an in-depth comparison about working as a Financial Analyst vs. working as an Investment Banker, two highly prestigious business careers.
  4. Professionals

    Who Needs to Take the Series 65?

    Most states require individuals to pass the Series 65 exam in order to act as investment advisors.
  5. Investing Basics

    How to Vet Financial Advisors Via BrokerCheck

    Many people research restaurants or movies, but few select brokers or financial advisors with much research. Here's how BrokerCheck can help.
  6. Professionals

    Career Advice: Financial Planner Vs. Stockbroker

    Read an in-depth review of a career as a financial planner as opposed to a career as a stockbroker, including how to decide which is best for you.
  7. Term

    Understanding the Maintenance Margin

    A maintenance margin is the minimum amount of equity that must be kept in a margin account.
  8. Investing Basics

    Brokers and RIAs: One and the Same?

    Brokers and registered investment advisors have some key differences. Here's what you need to know.
  9. Professionals

    Is a Google Robo-Advisor on the Horizon?

    It's possible that Google is looking to get into the robo-advisor business, either as a new venture or as a way to provide more benefits to employees.
  10. Professionals

    Understanding Series 6

    Upon successful completion of the Series 6, an individual will have the qualifications needed to sell open end mutual funds and variable annuities
  1. Maintenance Margin

    The minimum amount of equity that must be maintained in a margin ...
  2. Series 6

    A securities license entitling the holder to register as a limited ...
  3. Comprehensive Automated Risk Data ...

    The Comprehensive Automated Risk Data System (CARDS) is an initiative ...
  4. Corporate Financing Committee

    A regulatory group that reviews documentation that is submitted ...
  5. Series 79

    A examination to ensure a candidate is qualified to become a ...
  6. Research Analyst

    A person who prepares investigative reports on equity securities. ...
  1. Are hedge funds regulated by FINRA?

    Alternative investment vehicles such as hedge funds offer investors a wider range of possibilities due to certain exceptions ... Read Full Answer >>
  2. How are variable annuities regulated?

    The sale of a variable annuity is regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory ... Read Full Answer >>
  3. Do financial advisors need to pass the Series 7 exam?

    The exact nature of a financial advisor's job responsibilities determines whether he must have a Series 7 license. If a financial ... Read Full Answer >>
  4. Is a financial advisor required to have a degree?

    Financial advisors are not required to have university degrees. However, they are required to pass certain exams administered ... Read Full Answer >>
  5. Do financial advisors need to be approved by FINRA?

    The term "financial advisor" can refer to a couple of different roles. It most often refers to a broker-dealer or an investment ... Read Full Answer >>
  6. How does a broker decide which customers are eligible to open a margin account?

    Brokers have the sole discretion to determine which customers may open margin accounts with them, although there are regulations ... Read Full Answer >>
Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center