Systematic and Nonsystematic Risks

Systematic Risk/Un-diversifiable Risk/Market Risk

- risk that effects the entire market or market segment (fixed income or equity) - risk cannot be diversified away, impossible to protect a portfolio - market risk, interest rate risk, reinvestment risk, inflation risk - ex. government collapse, war, inflation

Unsystematic Risk/Residual Risk/Specific Risk/Diversifiable Risk

- risk that is unique to a company or industry - can be diversified away (to an extent) by other investments in your portfolio - ex. strikes, lawsuits

Inflation Risk/Purchasing Power Risk

- systematic risk - risk for a fixed-income investor that when bond prices fluctuate, the interest payments are not as sufficient as they had been initially - when the real return on your investment is reduced due to inflation eroding the purchasing power of your funds by the time they mature - ex. an investor invests in a fixed deposit yielding him 10% in one year, but if inflation has been 8% for that year, the real rate of return comes down to 2% (2% purchasing power on a 10% return)

Market Risk

- systematic risk - risk that changes in the overall economy will have adverse effects on individual securities regardless of the company's circumstances - risk due to market risk factors such as equity risk (risk of stock market prices or volatility changing), interest rate risk, currency risk, and commodity risk (risk of fluctuations in commodity prices)

Interest Rate Risk/Market Risk for Bonds

- systematic risk - risk that market conditions or the Federal Reserve push interest rates higher, lowering bond prices

Reinvestment Risk

- systematic risk - risk that a fixed-income investor will not be able to reinvest interest payments or the par value at attractive interest rates without increasing credit or market risk. - Happens when rates are falling - ex. an investor locked into a high-yielding fixed deposit at 9.5% and at maturity, when interest payments cease, interest rates are closer to 8%, and there are no bonds with a comparable interest rate. Investor will not take in as much income as he did previously.

Capital Risk

- unsystematic - risk that an investor will lose some or all of his money under circumstances unrelated to an issuers financial strength - more common with derivative products

Call Risk

- unsystematic risk - risk for a fixed-income investor that a bond might be called before maturity and the investor will be unable to reinvest the principal at a comparable rate of return - call risk leads to reinvestment risk - combated by call protection

Prepayment Risk

- unsystematic risk - risk that a borrower will repay the principal on a loan or bond before its maturity and thus deprive the lender of future interest payments - associated with call risk

Sovereign Risk

- unsystematic risk - risk that a country will default on its commercial debt obligations, and therefor all of its stocks, mutual funds, bonds, and other financial investment instruments are affected, as well as the countries it has financial relations with - effects the financial markets worldwide - countries with severe fiscal deficit (such as emerging economies) are considered more likely to be risky than a company with a low fiscal deficit (such as developed nations) - credit risk of a sovereign bond outside of the investor's home market

Political Risk

- unsystematic risk - risk that a country will suddenly change its policies - higher in emerging economies - ex. India's FDI policies will not be looking very attractive to foreign investors and stock prices will be negatively affected

Currency Risk/Foreign Exchange Risk

- unsystematic risk - risk that an investment dominated in one currency could decline in the value of that currency declines in its exchange rate with the US dollar - applies to any investment denoted in a currency other than the investor's home currency

Liquidity Risk/Marketability Risk

- unsystematic risk - risk that an investor might not be able to sell an investment quickly at a fair market price

Legislative Risk

- unsystematic risk - risk that changes in the laws that a business must comply with can have major effects on a company/industry - similar to regulatory risk

Regulatory Risk

- unsystematic risk - risk that changes in the rules that a business must comply with can have major effects on a company/industry - similar to legislative risk

Credit Risk/Default Risk/Financial Risk

- unsystematic risk - risk that companies who use debt financing are unable to meet principal and interest payments, they could go bankrupt and/or the investor could lose their investment - lowest with: government bonds - highest with: CDs (junk bonds) or companies with low credit ratings

Business Risk

- unsystematic risk - risk that due to poor management decisions, stock prices go down, earnings are lowered and at worst, company goes bankrupt, investors lose their investments