Risk is a term often heard in the world of investing, but it is not always clearly defined. It can vary by asset class or financial market and the list of risks include default risks, counterparty risks, and interest rate risks. Volatility is sometimes used interchangeably with risk, but the two terms have very different meanings. Furthermore, while some risks relate to just one company, others are relevant for specific industries, sectors, or even entire economies.
Systemic and Non-Systemic Risk
Risks are typically one of two types: systemic or non-systemic. A systemic risk is one that happens within a company or group of companies that can create havoc throughout an entire industry, sector, or economy. The financial crisis of 2007-2008 is an example, as a handful of large institutions threatened the entire financial system. This gave rise to the adage "too big to fail" because many of the large banks were deemed too important and thus needed a bailout from the U.S. government.
- Risk represents the potential for losses on investment and will vary depending on the asset or financial market.
- Counterparty risk, interest rate risk, and default risk are examples of risks in the financial world.
- Systemic risk refers to the risk that problems in one or a few companies will affect the entire sector or economy.
- Diversification mitigates non-systemic or unsystemic risk.
- Volatility refers to the speed of movement in price and is not specifically a source of risk.
Non-systemic risk relates to one party or company and is also called unsystemic or diversifiable risk. For example, a company might face risks of substantial losses due to legal proceedings. If so, the shares might be vulnerable if the company loses a lot of money due to an adverse court ruling. This risk is likely to impact just one company and not an entire industry. It is said that the diversification of a portfolio is the best way to mitigate non-systemic risk.
Volatility is the speed of movement in the price of an asset. A higher level of volatility indicates larger moves and wider changes in the value of an asset. Volatility is a non-directional value—a higher volatility asset has an equal likelihood of making a larger move up as it does down, which means they have a larger impact on the value of a portfolio. Some investors like volatility, while others try to avoid it as much as possible. Either way, a high volatility instrument carries greater risk in down markets because it suffers greater losses than the low volatility asset.
Counterparty risk is the possibility that one party of a contract defaults on an agreement. It is a risk, for example, in a credit default swap instrument. Credit swaps represent the exchange of cash flows between two parties and are typically based on changes in the underlying interest rates. Counterparty defaults on swap agreements were one of the main causes of the 2008 financial crisis.
Counterparty risk can also be a factor when dealing with other derivatives such as options and futures contracts, but the clearinghouse will ensure the terms of a contract are fulfilled if one of the parties runs into financial problems. Counterparty risk can affect bonds, trading transactions, or any instrument where one party depends on another to fulfill financial obligations.
Default Risk and Interest Rate Risk
Default risk is most often associated with bond and fixed income markets. It is the risk that a borrower may default on its loan obligations and not pay the lender outstanding amounts. Generally, a higher possibility of default results in a larger amount of interest paid on a bond. Thus, there is a risk/reward tradeoff investors must consider when looking at yields on bonds.
Interest rate risk refers to the potential losses in investment due to increasing interest rates. It is most notable when investing with bonds, as the price of a bond typically falls as interest rates rise. That's because bonds pay a fixed percentage rate and, as interest rates rise, existing bonds must compete with newer bonds that will be issued at higher rates. In order to do so, the price of the older bond must drop, and that is the risk of holding bonds as rates increase.