Quick Answer
Investment risks split into systematic (market-wide, cannot be diversified) and non-systematic (company-specific, can be diversified). Bond risks include credit, interest rate, reinvestment, and prepayment; broader risks cover inflation, currency, liquidity, capital, and political. Diversification kills company risk, rebalancing maintains the mix, and hedging is the only tool against systematic risk.
The whole unit on one sheet: every risk type, who it hits, and the three tools that manage it.
The Core Risks at a Glance
| Risk (aliases) | What it is | Who/what it hits most |
|---|---|---|
| Capital risk (principal risk) | Losing part or all of your original investment | Options (very high), equities, junk bonds |
| Credit risk (default risk) | Issuer fails to pay interest or principal | Junk bonds, revenue bonds, Exchange-Traded Notes (ETNs) |
| Inflation risk (purchasing power risk) | Rising prices cut your real return | Cash, long-term fixed-rate bonds |
| Interest rate risk | Rate changes move bond prices inversely | Long-maturity, low-coupon, zero-coupon bonds |
| Reinvestment risk | Cash flows must be reinvested at lower rates | High-coupon bonds, callable bonds, mortgage-backed securities (MBS) |
| Prepayment risk | Borrowers repay principal early (rates fall) | MBS, callable bonds |
| Currency risk (exchange rate risk) | Foreign exchange moves erase gains | American Depositary Receipts (ADRs), foreign bonds, emerging markets |
| Liquidity risk | Cannot sell fast without a price concession | Direct Participation Programs (DPPs), non-traded REITs, hedge funds |
| Market risk (systematic risk) | Whole market declines together | Every security; measured by beta |
| Non-systematic risk (business/company-specific) | One company or industry event | Concentrated single-stock holdings |
| Political risk | Government action or instability hurts returns | International/emerging markets, targeted domestic industries |
The One-Liners That Win Points
- Systematic risk cannot be diversified away; only hedging or asset allocation touches it. Non-systematic risk can be diversified away.
- Diversifiable risk = non-systematic risk. That is what diversification eliminates.
- Rates up, bond prices down; rates down, bond prices up (the most-tested SIE fact).
- Interest rate risk and reinvestment risk move in opposite directions.
- Zero-coupon bonds: maximum interest rate risk, zero reinvestment risk.
- Beta of the market benchmark is 1.0, not 0. Above 1 = more volatile; below 1 = less volatile.
- Investment grade vs. junk splits at BBB-/Baa3.
- Strong U.S. dollar hurts U.S. investors' foreign holdings; a weak dollar helps them.
Memory Aids (verbatim)
- PRIME (Systematic Risks): Purchasing power (inflation), Reinvestment risk, Interest rate risk, Market risk, Exchange rate (currency) risk. All five are systematic; diversification cannot eliminate them.
The Three Mitigation Tools
- Diversification: reduces non-systematic risk only; needs low correlation, not just many tickers.
- Rebalancing: returns a drifted portfolio to its target allocation; maintains risk, does not reduce it (buy low, sell high).
- Hedging: the only tool that reduces systematic risk (protective puts, index options, inverse ETFs); the premium cost eats into returns.
Top Gotchas
- U.S. Treasuries are free of credit risk, but still carry inflation and interest rate risk; capital-risk-free only if held to maturity.
- ETNs carry credit risk (unsecured bank debt); ETFs do not (they hold real securities in trust).
- Sovereign risk = a foreign government defaulting on its debt; it is not a synonym for political risk.
- Downgrade risk hits a bond's price, not its coupon.
- Callable bonds have the highest reinvestment risk; MBS also face extension risk when rates rise.
- A 30-year zero-coupon bond is the most rate-sensitive bond you can hold.
- A covered call caps upside and is not true downside protection; a protective put defines maximum loss with unlimited upside.
One-Breath Recap
Two families of risk: systematic hits everyone, non-systematic hits one name. Diversification erases company risk, rebalancing holds the plan, hedging is your only shield against the market. Know which risk each investment carries and which tool answers it, and the questions solve themselves.
Need more than the recap? This is a condensed summary. If it is not enough, read the full Investment Risks unit for the complete lesson.