Investment risk is a risk relating to the uncertainty of return derived from investing in an asset class. The investment risk is broadly classified into systematic and unsystematic risk. Systematic risk is a market-wide risk and is not company specific. Beta is a measure of systematic risk. Unsystematic or residual risk is a company-specific risk and hence can be mitigated. Letâs have a closer look at types of investment risks:
Credit or Default Risk: It is a risk that the borrower may default on the principal or the interest or both the obligations simultaneously. This type of risk is more particular in the case of bondholders. The sovereign bonds which are being issued by the countries have the least chances of defaulting as the central banks of any country wonât allow that to happen very easily. Hence such kind of instruments has the least amount of default risk. Contrastingly, the corporate bonds which are being issued by the corporations across the globe are inherently much riskier when it comes to the servicing of principal and coupons and thus have a larger spread leading to higher interest rates. The bonds which have a lesser chance of non-payment by the issuer is considered to be investment grade, while at the same time those with the higher chances are considered to be junk bonds.
Country Risk: It is a risk that a country may not be able to meet its financial commitments towards its sovereign obligations. This type of risk can most often be found in the emerging and developing economies which carry a considerable amount of debt and has an inflating fiscal deficit.
Timing risk: It is a risk that the investors are buy and sell the assets at the wrong time, for example where an investor buys high and sells low.
Foreign-Exchange Risk: Investors face such kind of risk when they invest in the securities and assets which are denominated in a foreign currency. As an example, if you live in Singapore and invest in an Australian stock, E.g., BHP Billiton by using Australian dollars, even if the share value appreciates, one may lose money if the Australian dollar depreciates in relation to the Singapore dollar.
Interest Rate Risk: Interest rate risk is the risk that a variation in the interest rates will have an impact on the market value of an asset. To provide some more perspective on the same, if one individual has bought a bond with at a coupon of 10% and post his buying the bond, the market interest rate rises, then the price of the bond held in the portfolio is slated to fall as the demand for those lower coupon bonds will decline. Hence, this interest rate risk impacts the value of bonds much more apparent than equity shares and is a thus considered critical risk to all the investors in debt securities.
Political Risk: It is the risk that the investment values could deteriorate due to severe or unstable political scenario. This kind of risk emanates from the change in the politico-economic policies and regulation â legislative bodies or military control, which may not favour the economic environment prevailing in the country.
Market Risk: It is a risk that an investment will face volatility in its value on account of the varying market conditions. This risk is also known as the systematic risk as the risk is market wide and not company specific. This risk is typically non-diversifiable as well, and thus the risk canât be reduced by taking the diversification measures. These risks typically involve Geo-political risk, interest rate risk, inflation risk, Foreign Exchange risk, liquidity risk, and socio-political risk.
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