Below we outline some common terms regarding investment risks.
Business risk is the risk associated with a particular security and the issuer of that security (unsystematic risk). Generally speaking, businesses within the same industry will have similar types of business risk (external business risk). For example, due to the internet, print based media companies have experienced contractions in their earnings. However, true business risk also describes risks specific to a company or firm (internal business risk). Examples of internal business risk would be fraud being committed by an employee or the destruction of a company’s manufacturing plant due to fire.
The risk, faced by a holder of a callable bond, that a bond issuer will take advantage of the callable bond feature and redeem the issue prior to maturity. This means the bondholder will receive payment on the value of the bond and, in most cases, will be reinvesting in a less favourable environment (one with a lower interest rate).
Commodity risk refers to the uncertainties of future market values and of the size of the future income, caused by the fluctuation in the prices of commodities. The most common example of commodity risk is how fluctuations in oil prices affect the operating costs of most businesses.
Counterparty risk is the risk to each party of a contract that the counterparty will not fulfil contractual requirements. This is a default risk as in any contract, there is a possibility that a party may intentionally or unintentionally defy the requirements. Counterparty risk can be reduced by having a credited organisation act as an intermediary between parties. Credit risk is a type of counterpart risk.
Credit risk, also known as default risk, is the risk that a borrower will fail to make payments which it is obligated to make. One example of credit risk is that the issuer of a bond is unable to pay coupon payments when due.
Currency/Exchange risk is a risk posed by exposure to unsuspected changes in the exchange rate between two different currencies. This risk is particularly elevated if all investments are held in a country’s foreign assets and the currency value of that particular country decreases significantly. Investors who hold financial assets in the global economy are subject to this risk and can suffer severe financial consequences.
The inflation risk is associated to the uncertainty over the future real value (after inflation) of an investment. Inflation refers to increases in the price paid for goods or services and is an important consideration for investors. This risk often accompanies fixed term deposits and savings account type investments as capital value remains the same and will not keep up with the pace of inflation, decreasing the real value.
Interest rate risk is usually associated with fixed-rate debt instruments. In this sense, interest rate risk is the possibility that the trading value of a fixed-rate debt instrument will decline in value as a result of a rise in interest rates. However, interest rate changes also affect the value of other financial securities. For example, sustained decreases to interest rates tend to result in the capital growth of property as borrowing becomes cheaper. Alternatively, a decrease in interest rates may lead to investors divesting their holdings in the bond market and investing in equities. Generally speaking, this may lead to capital appreciation of the share market.
Liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss. Compared to foreign exchange or listed shares, direct property carries high liquidity risk. Where shares and foreign exchange can be converted to domestic currency quickly, it usually takes far longer to sell a home.
The risk linked to ineffective, destructive or under performing management is known as manager risk. Management missteps may put companies at risk by undermining its status, image, stock price or the rating of its bonds. Consequences include bankruptcy of companies, reduction in the investment portfolio and the destruction of shareholder wealth.
Political risk is the risk that an investment’s returns could suffer due to political changes and decisions or instability in a country. These political changes could include a change in government, legislative bodies, other foreign policy makers or military control. Businesses can be affected through direct impacts (such as taxes) or indirect impacts (such as opportunity cost foregone). The outcome of a political risk could drag down investment returns or remove the ability to withdraw capital from an investment. Social risks are similar but are as a result of social changes that result in loss of value. Legislative risks are those as a consequence of government having the power to change laws that affect securities.