Before diving into specific risk types, you need a framework for how risk works in the securities industry.
What Is Risk?
- Risk is the possibility that an investment's actual return will differ from its expected return
- Every investment carries some degree of risk; there is no truly "risk-free" investment
- U.S. Treasury securities are considered the closest to risk-free, but they still carry inflation risk and interest rate risk
The Risk-Return Tradeoff
- Risk and return are positively correlated - higher potential return generally requires accepting higher risk
- Investors who want the safety of a savings account accept low returns
- Investors who want equity-like growth must accept the possibility of significant losses
Think of it this way: Risk and return are two sides of the same coin. A savings account feels safe, but inflation quietly eats away at your purchasing power. Stocks can grow your wealth faster, but the ride is bumpy. There is no shortcut that gives high returns without high risk.
- Understanding different risk types helps with matching investments to client objectives
Exam Tip: Gotchas
- The exam may present a "risk-free" investment. Even U.S. Treasuries carry inflation risk and interest rate risk. The only thing they are free of is credit (default) risk.
How Risk Types Connect
Investment risks fall into two broad categories that you will explore throughout this unit:
| Category | Also Called | Can Be Diversified? | Examples |
|---|---|---|---|
| Systematic risk | Market risk, non-diversifiable risk | No | Interest rate changes, inflation, recession |
| Non-systematic risk | Diversifiable risk, company-specific risk | Yes | CEO departure, product recall, lawsuit |
Memory Aid: PRIME (Systematic Risks)
- P - Purchasing power (inflation)
- R - Reinvestment risk
- I - Interest rate risk
- M - Market risk
- E - Exchange rate (currency) risk
All five are systematic; diversification cannot eliminate them.
Knowing which category each risk type belongs to is frequently tested; it determines which mitigation strategy applies.
Alternative Names to Recognize
The exam often swaps in a synonym for a risk you already know. The same risk can appear under several names, so recognizing every alias matters as much as understanding the concept.
| Risk | Also Known As |
|---|---|
| Market risk | Systematic risk, non-diversifiable risk |
| Non-systematic risk | Unsystematic risk, diversifiable risk, business risk, company-specific risk |
| Inflation risk | Purchasing power risk |
| Currency risk | Exchange rate risk |
| Credit risk | Default risk |
| Capital risk | Principal risk |
Interest rate risk, liquidity risk, prepayment risk, reinvestment risk, and political risk appear under their own names; they do not have a common one-word synonym.
Exam Tip: Gotchas
- The non-systematic row carries the most aliases. Unsystematic, diversifiable, business, and company-specific all point to the same diversifiable risk. If a question asks which risk diversification eliminates, any of those four phrasings is the target.
- Sovereign risk is not a synonym for political risk. Sovereign risk specifically means a foreign government defaulting on its debt (a credit concept for government bonds). Political risk is the broader category of instability and government action that can harm investments.
Now that you have the big picture, let's examine each risk type, starting with the most fundamental: capital risk.