Types of trading and investment risk
- Systematic and unsystematic risk
Systematic risk involves the probability of loss related to changes in the market that can’t be controlled. These changes include macroeconomic factors like politics, interest rates, and social and economic conditions, which could potentially influence the price in an adverse way.
Unsystematic risk relates to the possibility of loss that takes place on a microeconomic level. It’s normally associated with uncertainty about things that could be controlled, like managerial decisions or supply and demand in the industry.
- Business risk
Business risk is a threat to a company’s ability to meet its financial goals or payment of its debt. This risk may be a result of fluctuations in market forces, a change in the supply or demand for goods and services, or regulation being amended.
Business risk also exists when management decisions affect the company’s bottom line. This type of risk poses a threat to shareholders, because if a company goes bankrupt, common stockholders will be the last in line to receive their share of the proceeds when assets are sold.
- Volatility risk
Volatility risk is the possibility of loss due to the unpredictability of the market. If there’s uncertainty in the market, the trading range between asset price highs and lows becomes wider – exposing you to heightened levels of volatility.
So, it becomes important to track asset classes that display historical volatility to gauge future price changes. You can measure volatility using standard deviations, beta and options pricing models.
- Liquidity risk
Liquidity risk is the possibility of incurring loss because of the inability to buy or sell financial assets fast enough to get out of a position. When you have an open position but you can’t close it at your preferred level due to high liquidity, your position may result in a loss.
- Inflation risk
Inflation risk is the probability that the value of an asset (or your investment returns) will be affected by a decline in spending power. When inflation rises, there’s a threat that the cost of living will increase, plus a noticeable decline in buying power. As inflation rises, lenders change interest rates, which often leads to slow economic growth.
- Interest rate risk
Interest rate risk mostly affects long-term, fixed investments because fluctuations can cause a decline in the value of an asset. This type of risk the probability of an open position being adversely affected by exposure to changing interest rates.
When interest rates go up, the value of bonds will decline. On the other hand, when the interest rates go down, bonds will go up in value.
- Credit risk
Credit risk involves the probability of loss as a result of a company or individual defaulting on their repayment of a loan. A contractual obligation is created whereby the borrower agrees to repay a lender the principal amount, sometimes with interest included.
If you’re a trader, you’ll borrow from a broker to speculate on derivatives by only paying margin to open the position. This creates a credit risk for the lender if you don’t pay back what is owed.
- Counterparty risk
Counterparty risk is the potential of an individual, company or institution that’s involved in a trade or investment defaulting on their contractual responsibilities.
It’s generally when one party fails to meet the repayment obligations to get rid of the debt. Parties that have exposure to this risk include lenders (like banks) because they extend credit.
- Currency risk
Currency risk involves the possibility of loss if you have exposure to foreign exchange (forex) pairs. This market is notoriously volatile, and there’s increased potential for unpredictable loss.
For example, if you buy shares in Amazon from the UK, you’ll have to convert your pounds to USD to purchase the shares – exposing you to currency risk. When the times comes that you want to sell your investment, the exchange rate might have changed quite significantly, and you’ll be at the mercy of the new rate.
- Call risk
Call risk relates to the possibility that a bond issuer may recall an investment before the maturity date. The more time that passes after a coupon was issued, the lower the probability that the bond will be recalled.
Additionally, interest rates also play a major role in call risk being exercised. When interest rates drop, the issuer may call back the bond because they want to amend the terms of the bond to reflect the current rates.
