Types of Risk

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

Which One-Liners 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, plus liquidity, political, and call 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).
• Call risk: an issuer redeems a callable bond before maturity, forcing reinvestment at potentially lower rates.
• Sector risk and geopolitical risk are both systematic per NASAA's outline, alongside interest rate risk, even though sector risk only affects one industry.
• Opportunity cost is the return given up on the next-best alternative; it is a foregone gain, an implicit cost, NOT an actual loss.

What Is PRIME, the Memory Aid for the Systematic Five?

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

Which Gotchas Trip Students Up?

• 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 improves bankruptcy recovery but does not by itself determine overall risk or yield. 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, sector, geopolitical, and reinvestment, five of them captured by PRIME) hit the whole market or large segments of it and cannot be diversified away, mitigated only by hedging or asset allocation; unsystematic risks (credit, financial, legal and regulatory, issuer-specific, plus liquidity, political, and call) are specific to a company, industry, issuer, or country and are generally reduced, though not always fully eliminated, by holding many issuers. Beta measures systematic risk, and 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 improves bankruptcy recovery without alone determining a security's overall risk or return.

Need more than the recap? Read the full Types of Risk unit.