Risk, Investing Risk

November 23, 2010Investingby EconomyWatch




In investing parlance, risk refers to the probability of a monetary loss or actual returns from an investment being lower than the expected returns. There is an inverse relationship between investing risk and return. Investment options that are risky need to offer higher returns than those that are less risky in order to attract investors and make it worthwhile to take on the additional risk.

Types of Risks

A US Treasury bond is considered to be among the safest investments and equities are associated with higher risks. However, every investment involves risk, the difference being in the degree and the type.

Capital risk: This refers to the risk of losing the capital invested.

Currency risk: If one holds assets in a foreign currency, changes in the exchange rate can cause fluctuations in the asset value. A decline in the value of the foreign currency vis-à-vis the investor’s domestic currency will result in a reduction in the value of the asset in terms of the home currency. This is known as currency risk or exchange rate risk.

Liquidity risk: The risk associated with a delay in the trade of an asset is known as liquidity risk. An asset sale may be difficult due to the small size of the market or low demand, preventing the owner from converting the asset into cash.

Credit risk: The risk associated with the inability of the borrower to repay the principal is known as credit risk. Forinstance, the owner of a corporate bond could suffer losses in case the issuing company declares bankruptcy and is unable toredeem the bond.

Inflation risk: Inflation erodes the value of a currency. The possibility of the value of an asset declining due to contractionin the purchasing power of a currency is called inflation risk.

Interest rate risk: The possibility of devaluation of an interest-baring asset (such as bonds, stocks and loans) due to a change in the interest rate is known as interest rate risk.

Market risk: This refers to the possibility of a decline in the value of an investment due to a change in price. Price fluctuations may be caused by changes in the interest rate, foreign exchange rate, inflation or demand and supply situation.

Legal risk: The risk associated with changes in laws and regulations is called legal risk.

Counterparty risk: This refers to the risk of the other party in an agreement defaulting. For instance, the risk faced by an option owner of the other party not selling the underlying asset as agreed is called their counterparty risk.

There are a number of other risks that an investor may be exposed to. Before making a choice of investment, it is critical to understand the risk involved and ways in which one can minimize risk exposure.



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