Understanding Investment Risk: Sources And Their Impact

Risk is an inherent part of investing, and it refers to the possibility of losing some or all of an original investment. It is important to understand the sources of risk when making investment decisions. There are two broad categories of risk: systematic risk and unsystematic risk. Systematic risk, also known as market risk, affects the entire market or a large portion of it and is influenced by economic, political, and sociological factors. Unsystematic risk, on the other hand, is specific to a particular industry or company. While diversification can help mitigate unsystematic risk, systematic risk is more challenging to mitigate. Within these categories, there are various types of risk, including interest rate risk, inflation risk, liquidity risk, credit risk, and more. Understanding these sources of risk is crucial for investors to make informed decisions and manage their investment portfolios effectively.

Interest rate risk

There are different types of risk exposures that can arise when there are changes in interest rates, such as basis risk, options risk, term structure risk, and repricing risk. Basis risk arises from changes in the spread between different markets' interest rates. Options risk is the risk that the value of an option will change due to interest rate fluctuations. Term structure risk considers the impact of interest rate changes on the yield curve, which maps out the relationship between interest rates and bond yields across different maturities. Repricing risk refers to the possibility that a fixed-income security's value will be affected by changes in interest rates, leading to potential losses for investors.

Investors can manage interest rate risk through strategies such as laddering their investments, diversifying their portfolio, or investing in securities with different maturity dates. By adopting these approaches, investors can reduce the potential negative impact of changing interest rates on their bond holdings.

Equity price risk

Systematic equity price risk occurs when a global economic crisis affects multiple asset classes. This type of risk cannot be mitigated through diversification but can be hedged against by purchasing put options in an index exchange-traded fund. For example, an investor with holdings in multiple assets that represent an index can hedge against systematic equity price risk by buying put options in that index's exchange-traded fund.

Unsystematic equity price risk, on the other hand, can be mitigated through diversification. This type of risk is unique to a specific firm, industry, or property and can be reduced by spreading investments across different industries and asset types.

Foreign exchange risk

The risk arises when a company enters into a contract to buy or sell goods or services in a foreign currency. If the value of the currencies involved changes between the signing of the contract and the delivery of goods or services, one of the parties will face a loss. For example, if a US company signs a contract to buy goods from a European company for €5000, with payment due on delivery, the US company expects to pay $5000 if the exchange rate is €1 for $1. However, if the value of the US dollar depreciates to €1 for $1.10 by the time of delivery, the US company will have to pay $5500, resulting in a loss.

There are three main types of foreign exchange risk:

• Transaction risk: This occurs when a company buys or sells goods or services in a foreign currency, and the exchange rate changes between the time of the contract and the settlement of the transaction. It can be mitigated using forward contracts and options.
• Translation risk: This affects companies with subsidiaries in other countries. The financial statements of the subsidiary, which are in the local currency, need to be translated back into the parent company's currency. Changes in exchange rates during this process can impact the parent company's financial position.
• Economic risk: Also known as forecast risk or operating exposure, this type of risk impacts a company's market value due to continuous and unavoidable exposure to currency fluctuations. It is challenging to hedge against economic risk as it deals with unexpected changes in exchange rates.

• Using hedged exchange-traded funds (ETFs) that focus on international stocks and bonds.
• Investing in American companies that are expanding abroad, as they will deal with the foreign exchange risk.
• Quoting prices and requiring payment in US dollars, putting the risk on the customer.
• Arranging forward contracts to guarantee a pre-set exchange rate at a specific future date.
• Conducting transactions in multiple currencies to match currency inflows and outflows.
• Diversifying production facilities and using risk-sharing agreements.

Commodity price risk

A commodity's price is influenced by politics, seasonal changes, technology, and current market conditions. For example, an oversupply of crude oil could cause oil prices to fall, negatively impacting a company heavily invested in oil drilling wells. The company's profit margin would decrease as it continues to operate at the same cost while crude oil prices fall.

Credit risk

The Financial Crisis of 2007-2008 underscored the significance of credit risk management. The collapse of the subprime mortgage market exposed the lack of oversight in mortgage-backed securities, leading to widespread defaults and a wave of bankruptcies. This event highlighted the interconnected nature of the global economy, where the failure of one entity can trigger a cascade of negative consequences for others.

Credit rating agencies, such as Standard & Poor's, Fitch, and Moody's, play a crucial role in quantifying credit risk associated with bonds. These agencies use statistical analysis to evaluate factors such as assets under management and likely return on investment. They then assign a letter-grade rating to indicate the bond's creditworthiness, with AAA being the highest and D representing a current state of default.

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