Every investment carries risk. The key distinction for the Series 7 is whether a risk affects the entire market or just a specific company, because this determines whether diversification can help.
Systematic Risk (Market Risk)
- Systematic risk affects the entire market or broad market segments
- Cannot be eliminated through diversification; it is non-diversifiable
- Caused by macroeconomic factors: recessions, inflation, interest rate changes, geopolitical events, pandemics
- Can only be mitigated through hedging (options, inverse ETFs, futures) or asset allocation across uncorrelated asset classes
- Beta measures a security's sensitivity to systematic risk relative to the overall market
Beta values:
| Beta | Meaning | Example |
|---|---|---|
| 1.0 | Moves with the market | S&P 500 index fund |
| > 1.0 | More volatile than the market | Growth/tech stocks |
| < 1.0 | Less volatile than the market | Utility stocks |
| 0 | No correlation to the market | Risk-free assets |
Types of Systematic Risk
| Risk Type | What Happens | Most Vulnerable Securities |
|---|---|---|
| Market risk | Overall market declines, dragging down most securities | All equities, especially high-beta stocks |
| Interest rate risk | Rising rates reduce the market value of existing bonds | Long-term, low-coupon bonds; zero-coupon bonds have the greatest exposure |
| Inflation risk (purchasing power risk) | Rising prices erode the real value of fixed-income payments | Fixed-rate bonds, cash equivalents, money market instruments |
| Currency risk (exchange rate risk) | Foreign exchange rate movements reduce investment value | American Depositary Receipts (ADRs), international funds, foreign bonds |
| Political/legislative risk | Government actions (regulation, taxation, sanctions) negatively affect returns | International investments, emerging markets; also domestic securities exposed to regulatory change |
Memory Aid: PRIME = the five systematic risks
- Purchasing power (inflation) risk
- Reinvestment risk
- Interest rate risk
- Market risk
- Exchange rate (currency) risk
Nonsystematic Risk (Diversifiable Risk)
- Risk specific to a particular company, industry, or sector
- Can be reduced or eliminated through diversification: holding securities across different companies, industries, and geographies
- Examples: management fraud, product recalls, labor strikes, competitive disruption, single-industry regulatory changes
Types of Nonsystematic Risk
| Risk Type | What Happens |
|---|---|
| Business risk | A company's operations or management decisions cause a decline in earnings or viability |
| Financial risk | A company's use of debt (leverage) creates risk of default; highly leveraged firms face greater risk |
| Credit risk (default risk) | A bond issuer fails to make interest or principal payments; measured by credit ratings |
| Event risk | A specific, unexpected event (merger, natural disaster, fraud scandal) dramatically affects a single issuer |
Exam Tip: Gotchas
Systematic risk CANNOT be diversified away; only hedging or asset allocation can mitigate it. Nonsystematic risk CAN be diversified away. The risk that can be eliminated through diversification is always nonsystematic/diversifiable risk, never systematic/market risk.
Call Risk
- The risk that a bond issuer redeems (calls) the bond before maturity, typically when interest rates have fallen
- The investor receives the call price (usually par or a slight premium) and must reinvest at lower prevailing rates
- Call risk is highest when interest rates are falling (issuers refinance at lower rates)
- Callable bonds compensate for call risk by offering higher yields than comparable non-callable bonds
- Municipal bonds are commonly callable; a bond trading at a premium is most likely to be called
- Call risk combines with reinvestment risk: the called bond's proceeds must be reinvested at lower rates
Reinvestment Risk
- The risk that cash flows (coupons, maturing principal, called bonds) will be reinvested at lower interest rates
- Greatest when interest rates are falling
- High-coupon bonds have greater reinvestment risk (more periodic cash flow to reinvest)
- Callable bonds and mortgage-backed securities (MBS) have elevated reinvestment risk due to early return of principal
- Zero-coupon bonds have NO reinvestment risk (no periodic cash flows; all return comes at maturity)
- Yield to maturity (YTM) calculations assume all coupons are reinvested at the YTM rate; if actual reinvestment rates are lower, the realized return falls short of YTM
Exam Tip: Gotchas
Call risk and reinvestment risk are closely linked but distinct. Call risk is the risk the bond is redeemed early. Reinvestment risk is the risk that the proceeds must be reinvested at lower rates. A question asking about call risk is asking about early redemption; a question about reinvestment risk is asking about the rate environment for reinvesting cash flows.
Interest Rate Risk vs. Reinvestment Risk
These two risks work in opposite directions:
Think of it this way: Interest rate risk hurts you when rates go up (your existing bond loses value). Reinvestment risk hurts you when rates go down (you have to reinvest cash flows at lower rates). They pull in opposite directions, so a bond that has high exposure to one tends to have low exposure to the other.
| Risk Type | Triggered By | Worst For |
|---|---|---|
| Interest rate risk | Rates rise (bond prices fall) | Long-term, low-coupon bonds; zero-coupon bonds |
| Reinvestment risk | Rates fall (reinvestment rates drop) | High-coupon bonds, callable bonds, MBS |
Exam Tip: Gotchas
Zero-coupon bonds have MAXIMUM interest rate risk but ZERO reinvestment risk. High-coupon callable bonds have significant reinvestment risk but less interest rate risk per dollar of price.
Timing Risk
- The risk of buying or selling at the wrong time: entering the market at a peak or exiting at a trough
- Also called market timing risk
- Investors who attempt to time the market risk missing rallies or locking in losses
- Dollar-cost averaging (investing fixed amounts at regular intervals) mitigates timing risk by reducing the impact of entering at any single price point
- Particularly relevant for lump-sum investments where the investor commits a large amount at once
Liquidity Risk
- The risk of being unable to sell an investment quickly at or near its current market value without a significant price concession
- Illiquid investments may take longer to sell or require steep discounts
| Highly Liquid | Illiquid |
|---|---|
| U.S. Treasuries | Direct participation programs (DPPs) |
| Large-cap stocks | Hedge funds |
| ETFs | Non-traded REITs |
| Open-end mutual funds (redeemed at net asset value, or NAV) | Thinly traded securities |
| Restricted securities (under the restricted-stock resale rule) | |
| Private placements |
- Closed-end funds may trade at a discount to NAV, reflecting liquidity risk in the underlying portfolio
- Liquidity risk is a major disclosure obligation for alternative investments
Prepayment and Extension Risk
These are two sides of the same coin, most critical for mortgage-backed securities (MBS) and collateralized mortgage obligations (CMOs):
- Prepayment risk: Borrowers repay principal earlier than expected; investors receive cash back sooner and must reinvest at lower rates
- Extension risk: The opposite; when rates rise, prepayments slow and the investment's effective maturity extends beyond expectations
| Rate Environment | What Happens | Risk Name |
|---|---|---|
| Rates fall | Borrowers refinance, principal returned too fast | Prepayment risk |
| Rates rise | Borrowers hold mortgages longer, principal returned too slowly | Extension risk |
Exam Tip: Gotchas
Falling rates = prepayment risk. Rising rates = extension risk.
Opportunity Cost
- The potential return forgone by choosing one investment over another
- Not a loss in the traditional sense, but a cost of the investment decision
- Example: an investor in a 3% CD forgoes the potential higher returns of equities during a bull market
- Relevant to suitability: recommending an overly low-risk investment to a growth-oriented client may expose them to opportunity cost