Types of Risk

The whole unit on one sheet: the two risk families, opportunity cost, and the liquidation ladder the exam loves.

The One-Liners That Win Points

• Systematic risk = non-diversifiable = market risk. Diversification does nothing; only hedging or asset allocation mitigates it. Measured by beta.
• Interest rate risk: rates and bond prices move inversely. Longer maturity plus lower coupon equals greater sensitivity.
• Inflation risk (purchasing power risk) hits fixed-income hardest, since payments are fixed in nominal terms.
• Exchange rate risk (currency risk) applies to any foreign-currency investment; a strengthening dollar can erase a positive local return.
• Reinvestment risk: cash flows must be reinvested at lower prevailing rates when rates fall.
• Unsystematic risk = diversifiable = company-specific. Named by the North American Securities Administrators Association (NASAA): credit, legal/regulatory, financial, and issuer-specific (business) risk.
• Credit risk (default risk): issuer fails to pay; United States Treasuries carry virtually none.
• Financial risk comes from leverage (debt), not operations; business risk is operational quality. A great business can still fail from too much debt.
• Liquidity risk: cannot sell quickly without a price concession (direct participation programs, non-traded real estate investment trusts, hedge funds, restricted securities).
• Opportunity cost is the return given up on the next-best alternative; it is a foregone gain, an implicit cost, NOT an actual loss.

Memory Aid: PRIME for the Systematic Five

PRIME captures the five systematic risks most commonly tested: Purchasing power (inflation), Reinvestment, Interest rate, Market, Exchange rate (currency).

Top Gotchas

• Systematic vs. unsystematic: if a question says "can be reduced through diversification," the answer is unsystematic. Credit risk is unsystematic even in a recession; interest rate risk is systematic because it hits all fixed-income at once.
• Political risk is unsystematic (one country's policies); geopolitical risk is systematic (broad global market).
• Diversification and asset allocation are different tools. Diversification (many securities) cancels unsystematic risk; asset allocation (mix of stocks, bonds, cash) manages systematic risk. Two hundred stocks are diversified but still carry full market risk.
• Utility stocks fall when rates rise because utilities are highly leveraged (sector risk), NOT because they are fixed-income.
• Liquidation ladder (debt always before equity): secured debt, then unsecured debentures, then subordinated debt, then preferred stock, then common stock (residual, often nothing).
• Higher priority equals lower risk equals lower expected return. Least risk in bankruptcy is secured bondholders, not preferred stockholders.
• Preferred stock is equity; it is paid AFTER every creditor, including subordinated debenture holders. Adjectives do not matter: a junior subordinated debenture still beats a senior preferred stock.

One-Breath Recap

Risk splits two ways: systematic risks (market, interest rate, inflation, currency, reinvestment, captured by PRIME) hit the whole market and cannot be diversified away, mitigated only by hedging or asset allocation; unsystematic risks (credit, financial, legal/regulatory, issuer-specific, plus liquidity, political, and call) are company-specific and diversified away by holding many issuers. Beta measures systematic risk. Opportunity cost is a foregone gain, not a loss. In liquidation, debt always beats equity: secured, unsecured, subordinated, preferred, then common last, and higher priority always means lower risk and lower return.

Need more than the recap? This is a condensed summary. If it is not enough, read the full Types of Risk unit for the complete lesson.