15.2.2 Types Of Risks

Learn about the various types of risks involved in investing, including inflation rate risk, business risk, political risk, liquidity risk, interest rate risk, and foreign investment risk. Understanding these risks can help investors make more informed decisions.

15.2.2 Types Of Risks

Types of Risks

Investing in the markets entails the following types of risks, each of which can add to the uncertainty of expected returns for a particular security:

Inflation Rate Risk

Inflation rate risk is the risk that inflation will reduce future purchasing power and the real return on investments.

Business Risk

Business risk is the risk that a company’s earnings will be reduced as a result of factors such as a labor strike, the introduction of a new product into the market, or the outperformance of a competing firm. The uncertainty regarding a company’s future performance is its basic business risk.

Political Risk

Political risk refers to the risk of unfavorable changes in government policies—for instance, the government may increase taxes on foreign direct investment, making it less attractive for foreign investors. This risk also encompasses the instability associated with investing in a particular country, such as a war-torn region.

Liquidity Risk

A liquid asset is one that can be bought or sold at a fair price and converted to cash on short notice. Liquidity risk is the risk that an investor will not be able to buy or sell a security at a fair price quickly enough due to limited buying or selling opportunities.

Systematic and Non-systematic Risk

The risk of a portfolio stems from the combined risks intrinsic to the various securities within it. While certain risks can be mitigated or diversified away, others, known as systematic risks, cannot be eliminated through diversification.

Systematic Risk

Systematic risk, also known as market risk, is associated with factors such as the business cycle, inflation, and high interest rates. When stock market averages fall, most individual stocks in the market also fall. When interest rates rise, nearly every bond and preferred share decrease in value. Systematic risk cannot be diversified away.

    flowchart LR
	    title(Systematic Risk)
	    marketRisk[Systematic Risk: \n - Market Risk, Business Cycle, Inflation, High Interest Rates]
	    stockMarketAverages[Stock Market Averages Fall]
	    individualStocks[Most Individual Stocks Fall]
	    interestRates[Interest Rates Rise]
	    bondsAndShares[Bonds & Preferred Shares Decrease in Value]
	
	    marketRisk --> stockMarketAverages
	    marketRisk --> interestRates
	    stockMarketAverages --> individualStocks
	    interestRates --> bondsAndShares
	    

Explanation of Diagram:

  • Market Risk elements: Listed are various aspects contributing to systematic risk, including the business cycle, inflation, and high interest rates.
  • Impact paths: Arrows show how market influences lead to specific outcomes in stock and bond prices.
  • Individual elements: Each entity is a part of the systematic risk and shows the chain of impact. This flowchart clarifies the propagation of effects under the influence of systematic risk on different financial products.

Did You Know? The more a portfolio gets diversified within a certain asset class, the closer it starts mirroring the market for that asset.

Non-systematic Risk

Non-systematic risk, or specific risk, is the risk that a particular security or a specific group of securities will deviate from market expectations. This type of risk can be mitigated through diversification. For instance, the stock of a bank could increase while the S&P/TSX Composite Index falls, or financial companies could see declines that are more pronounced than those of the index itself.

    flowchart LR
	    nonSystematicRisk[Non-systematic Risk] -->|Specific to Company| bankStockIncrease[Bank Stock Increases]
	    nonSystematicRisk -.->|Can be mitigated by| diversifiable
	    nonSystematicRisk -->|Specific to Sector| financialDecline[Financial Companies Decline]
	    
	    marketIndex[Market Index #40;e.g., S&P/TSX Composite#41;]
	    marketIndex -->|Contrasts with| bankStockIncrease
	    marketIndex -->|Contrasts with| financialDeclare
	
	    diversifiable[Diversifiable Through Diversification]
	
	    classDef boxStyle fill:#bbf,stroke:#333,stroke-width:2px;
	    classDef exampleLine stroke:#333,stroke-width:1px,stroke-dasharray: 5, 5;
	    class nonSystematicRisk,marketIndex boxSyle;
	    class diversifiable exampleLine;

Explanation:

  • Non-systematic Risk: This node represents the specific risks associated with individual securities or sectors.
  • Bank Stock Increases: Demonstrates an example where a bank’s stock might increase in value even if the overall market is declining.
  • Financial Companies Decline: Shows how a specific sector such as financial companies could decline, contrasting with the broader market performance.
  • Market Index (e.g., S&P/TSX Composite): Represents the general market performance, used as a baseline to illustrate how non-systematic risk can cause deviations.
  • **Diversifiable Through Diversification: **This connection indicates that non-systematic risk can be mitigated through diversification. This flowchart effectively captures the essence of non-systematic risk, highlighting its independence from market movements and showing how diversification can reduce its impacts.

📚✨ Quiz Time! ✨📚

🧐 Assess and Solidify Your Understanding

Welcome to the Knowledge Checkpoint! You’ll find 10 carefully curated quizzes designed to reinforce the key concepts covered. These questions will help you gauge your grasp of the material, identify areas that need further review, and ensure you’re on the right track towards mastering the content for the Canadian Securities certification exams. Take your time, think critically, and use these quizzes as a tool to enhance your learning journey. 📘✨

Good luck! 🍀💪

## What is inflation rate risk? - [ ] The risk that a company's earnings will fall due to labor strikes - [x] The risk that inflation will reduce future purchasing power and the real return on investments - [ ] The risk of unfavorable changes in government policies - [ ] The risk of not being able to convert an asset to cash quickly > **Explanation:** Inflation rate risk refers to the possibility that the value of investments will be eroded due to rising inflation, diminishing the purchasing power and real returns. ## Which of the following is an example of business risk? - [x] The risk that a company's earnings will be reduced due to the introduction of a new product by a competitor - [ ] The risk of unfavorable changes in exchange rates - [ ] The risk that an investor cannot sell a security at a fair price quickly - [ ] The risk associated with investing in every capital market > **Explanation:** Business risk relates to uncertainties regarding a company's operational performance due to factors like market competition, product introduction, or labor issues. ## What characterizes political risk? - [ ] The risk of not being able to reinvest at the same rate - [x] The risk of unfavorable changes in government policies - [ ] The risk related to the liquidity of small-cap companies - [ ] The risk that a security cannot be sold at a fair price > **Explanation:** Political risk involves changes in government policies or the general instability in a country, which can negatively impact investment returns. ## What is liquidity risk? - [x] The risk that an investor will not be able to buy or sell a security at a fair price quickly enough - [ ] The risk associated with changes in exchange rates - [ ] The risk that interest rates will affect investment value - [ ] The risk that a company's earnings will be reduced > **Explanation:** Liquidity risk is the risk of an investor being unable to quickly buy or sell a security at its market value due to limited trading opportunities. ## How does interest rate risk affect fixed-income securities? - [x] If interest rates rise, the value of the investment falls - [ ] If interest rates rise, the value of the investment rises - [ ] If interest rates fall, the investment yields a higher return - [ ] If interest rates fall, the investment is unaffected > **Explanation:** Interest rate risk involves the inverse relationship between interest rates and bond prices, where an increase in interest rates causes bond prices to fall. ## What is foreign exchange rate risk? - [x] The risk of loss from unfavorable changes in exchange rates - [ ] The risk that a company will default on a loan - [ ] The risk of political instability in a foreign country - [ ] The risk of limited trading opportunities in foreign markets > **Explanation:** Foreign exchange rate risk is the risk that fluctuations in currency exchange rates will negatively impact the value of investments made in foreign countries. ## What is default risk? - [ ] The risk that inflation will erode investment returns - [ ] The risk of fluctuating interest rates - [ ] The risk of being unable to sell a security quickly - [x] The risk that a company will be unable to make interest payments or repay the principal amount of a loan when it is due > **Explanation:** Default risk is the possibility that a company might fail to meet its debt obligations, both in terms of interest payments and repaying the principal. ## What distinguishes systematic risk from non-systematic risk? - [ ] Systematic risk can be eliminated through diversification - [x] Systematic risk is associated with general market factors, while non-systematic risk is specific to individual securities - [ ] Non-systematic risk cannot be reduced or eliminated - [ ] Non-systematic risk impacts all securities equally > **Explanation:** Systematic risk affects the entire market and cannot be diversified away, whereas non-systematic (specific) risk is limited to individual securities and can be reduced through diversification. ## What does standard deviation measure in the context of investment risk? - [x] The range of possible future outcomes based on past performance - [ ] The correlation of a security's performance with the market as a whole - [ ] The risk of not selling a security quickly at a fair price - [ ] The probability of a company defaulting on its debt > **Explanation:** Standard deviation measures the volatility of returns and gives an indication of the risk associated with individual securities or a portfolio based on historical performance. ## What does a higher beta coefficient indicate? - [ ] Lower market-related risk - [ ] Greater likelihood of default - [ ] Higher liquidity risk - [x] Greater sensitivity of securities or a portfolio to market movements > **Explanation:** A higher beta indicates that a security or portfolio is more sensitive to market changes, implying greater market-related risk.

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