Many sources of risk bring this uncertainty, and they can be divided into two broad types:
Market risk, also known as systematic, economic, or undiversifiable risk. Market risk affects all securities in a market, and cannot be eliminated through diversification. Company-specific risk, which is diversifiable or unsystematic risk. This type of risk does not affect all securities and can be reduced through diversification.
Types of Market Risk
Market risk is also called systematic risk because it is not unique to a particular investment. These risks affect an entire market or class of investments. Some examples of systematic risks are:
Interest-Rate Risk
Interest rates fluctuate over time due to the business cycle and changes in monetary policy. When interest rates change, the prices of financial securities usually are affected. When interest rates rise, bond prices and sometimes stocks tend to fall; when interest rates fall, stock and bond prices tend to rise.
Reinvestment Rate Risk
Some investments provide the investor with periodic cash flow, or yield. Some stocks provide cash flow in the form of dividends, and bondholders receive regular interest payments. An investor may decide to spend these cash receipts or reinvest them. An investor who chooses to reinvest the cash receipts may not be able to earn the same rate of return as they did on the original investment. For example, if an investor holds a bond that makes a 6% coupon payment, but interest rates have fallen since that bond was issued, that investor may only be able to buy a similar bond with a 5% coupon.
Inflation Risk
Inflation risk, or purchasing power risk, is the chance that inflation will reduce the real purchasing power of an investment and the cash flows it provides. Because of purchasing power risk, investors hope to earn a rate of return that exceeds inflation over time.
Exchange-Rate Risk
Foreign investments expose an investor to currency risk, or the risk that changes in the exchange rate between currencies in different countries will occur. Exchange-rate risk refers to the uncertainty of the exchange rate when an investor ultimately converts an investment in another country back to their own currency.
Political Risk
Political risk, also known as sovereign risk, is the risk that a country’s legal environment will negatively affect an investment in a foreign country. For example, if you invest in foreign-government (or “sovereign”) bonds, investors face the risk that the government could default. There is also the threat that a foreign government may seize control of privately owned businesses that you have invested in. Market risk can be managed by your choice of asset allocation. For example, exchange-rate risk can be mitigated by reducing the percentage of your portfolio made up of foreign investments.
Alternatives to Market Risk
In addition to market risk, there are also unsystematic risks that only affect a specific company. Because these risks are only relevant for an individual firm, they can be reduced through diversification. In fact, you can eliminate unsystematic risk entirely by holding a large variety of different financial securities.
Business Risk
Business risk, also called operational risk, is any risk that arises due to the natural changes of business that potentially can reduce a company’s profits.
Financial Risk
Financial risk is the risk a business faces due to its dependence on and sources of financing, namely debt and the use of leverage. This exposes the company to risk in the form of an obligation to repay principal and interest.
Market Risk vs. Company-Specific Risk
Company-specific risks can be completely eliminated through diversification by holding many securities from different issuers.
