Traditionally investors have talked about several sources of total risks, such as interest rate risk and market risk, which are explained below, because these terms are used so widely. Following this discussion, we will define the modern portfolio sources of risk, which will be used later when we discuss portfolio and capital market theory.
- Interest Rate Risk:
The variability in a security’s return resulting from changes in the level of interest rates is referred to as interest rate risk. Such changes generally affect securities inversely; that is, other things being equal, security prices move inversely to interest rates. Interest rate risk affects bonds more directly than common stocks, but it affects both and is a very important consideration for most investors.
The variability in returns resulting from fluctuations in the overall market that is, the aggregate stock market is referred to as market risk: All securities are exposed to market risk, although it affects primarily common stocks. Market risk includes a wide range of factors exogenous to securities themselves, including recessions, wars, structural changes in .the economy, and changes in consumer preferences.
- Inflation Risk:
A factor affecting all securities is purchasing power risk, or the chance that the purchasing power of invested dollars will decline/With uncertain inflation, the real (inflation-adjusted) return involves risk even if the nominal return is safe (e.g., a Treasury bond).
The risk of doing business in a particular industry or environment is called business, For example, AT&T, the traditional telephone powerhouse, faces major changes today in the rapidly changing telecommunications industry.
- Financial Risk:
Financial risk is associated with the use of debt financing by The larger the proportion of assets financed by debt (as opposed to equity), the larger the variability in the returns, other things being equal. Financial risk involves the concept of financial leverage, which is explained in managerial finance courses.
- Liquidity Risk:
Liquidity risk is the risk associated with the particular secondary market in which a security trades. An investment that can be bought or sold quickly and without significant price concession is considered to be liquid. The more uncertainty about the time element arid the price concession, the greater the liquidity A Treasury bill has little or no liquidity risk, whereas a small over-the-counter (OTC) stock may have substantial liquidity risk.
All investors who invest internationally in today’s increasingly global investment arena face the prospect of uncertainty in the returns after they-convert the foreign gains back to their own currency Unlike the past when most S. investors ignored international investing alternatives, investors today must recognize and understand exchange rate risk, which can be defined as the variability in returns on securities caused by currency fluctuations. Exchange rate risk is sometimes called currency risk. For example, a U.S. investor who buys a German stock denominated in marks must ultimately convert the returns from this stock back to dollars. If the exchange rate has moved against the investor, losses from these” exchange rate’ movements can partially or totally negate the original return earned.
- Country Risk:
Country risk also referred to as political risk, is an important risk for investors today probably more important now than in the past. With more investors investing internationally, both directly and indirectly, the political, and therefore economic, stability and viability of a country’s economy need to be considered. The United States arguably has the lowest country, risk, and other countries can be judged on a relative basis, using the United States as a benchmark. Examples of countries that needed careful monitoring in the 1990s because of country risk included the former Soviet Union and Yugoslavia, China, Hong Kong, and South Africa. In the early part of the twenty-first century, several countries in South America, Turkey, Russia, and Hong Kong, among others, require careful attention.