There are many ways to define and measure investment risk. Here is a list of the types of risk investors face in the capital markets.
Beta
Beta measures the relationship between a security’s returns and those of the overall stock market. A beta of 1 indicates that the security’s price will move with the market. A beta of less than 1 means that the security will be less sensitive to moves in the overall market. A beta of greater than 1 indicates that the security’s price will be more sensitive to moves in the overall market. Beta is used in the capital asset pricing model (CAPM) to estimate the expected return of an asset based on its volatility (i.e. beta).
Concentration risk
Concentration risk – the risk of loss due to overexposure to one investment, asset class, risk factor, etc.
Conditional Value at Risk (CVaR)
A risk assessment technique often used to reduce the probability a portfolio will incur large losses. This is performed by assessing the likelihood (at a specific confidence level) that a specific loss will exceed the value at risk. Mathematically speaking, CVaR is derived by taking a weighted average between the value at risk and losses exceeding the value at risk. Conditional Value at Risk was created to be an extension of Value at Risk (VaR). The VaR model does allow managers to limit the likelihood of incurring losses caused by certain types of risk – but not all risks. The problem with relying solely on the VaR model is that the scope of risk assessed is limited, since the tail end of the distribution of loss is not typically assessed. Therefore, if losses are incurred, the amount of the losses will be substantial in value. This term is also known as “Mean Excess Loss”, “Mean Shortfall” and “Tail VaR”.
Country risk
Country risk – also known as sovereign risk – is the risk that a foreign government will default on its debt because of political or economic instability or regulatory changes.
Credit risk
Credit risk – the chance that a bond issuer will not make the coupon payments or principal repayment to its bondholders. In other words, it is the chance the issuer will default. Rating agencies such as Standard & Poor’s (S&P) analyze bond issuers and issue their view on each one’s credit- worthiness. Credit risk can arise from different circumstances. Examples:
- – poor or falling cash flow from operations (which is often needed to make the interest and principal payments),
- – rising interest rates (if the bonds are floating-rate notes, rising interest rates increase the required interest payments making it harder to service debt),
- – changes in the nature of the marketplace that adversely affect the issuer (such as a change in technology, an increase in competitors, or regulatory changes)
- – the credit risk associated with foreign bonds also includes the home country’s sociopolitical situation and the stability and regulatory practices of its government (called sovereign risk)
Currency risk
Currency risk is the risk that changes in currency exchange rates cause the value of an investment to decline.
Downside deviation
A measure of only negative deviations from the average. It is a measure of downside risk. The Sortino Ratio is a measure of downside risk that includes downside deviation as the denominator and the risk premium (expected return minus the risk-free rate) as the numerator.
Economic risk
Economic factors such as economic growth, inflation, employment, interest rates and business sentiment pose risks to investment.
Extension risk
Extension risk – the risk of a security’s expected maturity lengthening in duration due to the deceleration of prepayments.
Inflation risk
Inflation erodes the value of money by reducing future purchasing power.
Interest rate risk
Interest rate risk – the risk that interest rates change and impact the value of one’s investment. Example: Interest rates and bond price:
An investor owns a bond that trades at par value and carries a yield of 4%. Suppose that the prevailing market interest rate surges to 5%. What will happen? Investors will want to sell the 4% bonds in favor of a bond that retunrs 5%, which in turn forces the 4% bonds’ price below par.
Kurtosis (also know as ‘fat tails’)
A statistical measure used to describe how data is distributed around the mean. It is sometimes referred to as the “volatility of volatility.” Used generally in the statistical field, kurtosis describes trends in charts. A high kurtosis portrays a chart with fat tails and a low, even distribution, whereas a low kurtosis portrays a chart with skinny tails and a distribution concentrated toward the mean.
Liquidity risk
Liquidity risk is the risk that investments will be difficult to sell.
Longevity risk
Longevity risk is the risk of outliving your assets.
Political risk
Political factors include changes in government, political uncertainty, and international conflicts that can impact the risk of an investment.
Reinvestment risk
Reinvestment risk is the risk of having to reinvest proceeds at a lower rate than the rate the funds were previously earning. Example: when interest rates fall over time and callable bonds are exercised by the issuers. The callable feature allows the issuer to redeem the bond prior to maturity. As a result, the bondholder receives the principal payment, which is often at a slight premium to the par value. However, the downsite to a bond call is that the investor is then left with a pile of cash that he or she may not be able to reinvest at a comparable rate. This reinvestment risk can have a major adverse impact on an individual’s investment returns over time.
Sequencing risk
Sequencing risk is the risk to the value of an investment portfolio from the order (or sequence) in which investment returns occur.
Shortfall risk
Shortfall risk – the risk of failing to meet your long-term investment goal.
Skewness
Skewness is any asymmetry from the normal distribution in a set of statistical data. Skewness can be either negative or positive, depending on whether data points are skewed to the left (negative skew) or to the right (positive skew) of the data average. Skewness is extremely important to finance and investing. Most sets of data, including stock prices and asset returns, have either positive or negative skew rather than following the balanced normal distribution (which has a skewness of zero). By knowing which way data is skewed, one can better estimate whether a given (or future) data point will be more or less than the mean. Most advanced economic analysis models study data for skewness and incorporate this into their calculations. Skewness risk is the risk that a model assumes a normal distribution of data when in fact data is skewed to the left or right of the mean.
Sovereign risk
Sovereign risk – also known as country risk – is the risk that a foreign government will default on its debt because of political or economic instability or regulatory changes.
Standard deviation
Standard deviation measures the dispersion of returns from their mean. The more spread apart the returns, the greater the deviation. Standard deviation provides a historical record of the investment’s volatility and is often used to estimate future volatility.
Tail risk
Tail risk is the risk that an investment will move more than three standard deviations from the mean.
Value at Risk (VaR)
Value at Risk is a statistical technique used to measure and quantify the level of financial risk within a firm or investment portfolio over a specific time frame. Value at Risk is used by risk managers in order to measure and control the level of risk which the firm undertakes. The risk manager’s job is to ensure that risks are not taken beyond the level at which the firm can absorb the losses of a probable worst outcome. Value at Risk is measured in three variables: the amount of potential loss, the probability of that amount of loss, and the time frame. For example, a financial firm may determine that it has a 5% one month value at risk of $100 million. This means that there is a 5% chance that the firm could lose more than $100 million in any given month. Therefore, a $100 million loss should be expected to occur once every 20 months.
Source: Allianz Global Investors, Investopedia