We all have heard the term ‘risk’ when we usually talk about trading or investing, but not all of us are familiar with the risks commonly associated with the market and trading. The prospects of an investment may seem lucrative, but is it really worth taking a risk with that? This is where experience and a good advice play an important role.
Risk is basically the ability to bear a loss. Your investments and risk basically go hand in hand. But risk is not only limited to the market movements. There are a number of different types of risks that can affect investments and returns on them. Having knowledge about the different types of risks is the key to a good portfolio, so as to maximise returns on the investments.
All investments are affected broadly by systematic and unsystematic risks. Systematic risk influences a large number of assets. A significant political event, for example, could affect several of the assets invested in.
Unsystematic risk is sometimes referred to as "specific risk". This kind of risk affects a few companies or a small number of securities invested in. An example is news that affects a specific stock such as a sudden strike by employees which can affect production of certain companies leading to a loss in income and reduction in the price of shares and equities of the companies.
1) Interest Rate Risk
Interest rate risk is the risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bond and debt instruments more directly than stocks. Any reduction in interest rates will increase the value of the instrument and vice versa. Interest rates keep on fluctuating and so is the risk.
2) Foreign Exchange Risk
Investing in foreign countries carries the exchange rate risk. Foreign-exchange risk applies to all financial instruments that are in a currency other than in domestic currency. Depreciation in the value of the foreign currency could neutralise any income earned from that asset. The rates of currencies keep on changing and so is the risk associated with them. The INR for example is very volatile against the USD exchange rates. A small movement in the rate can affect the investment on a great scale.
3) Country Risk
Country risk refers to the risk related to a country as a whole. There is a possibility that it will not be able to honour its financial commitments. When a country defaults on its obligations, this can affect the performance of all securities in that country as well as other countries it has relations with. Country risk applies to all types of securities issued in that country.
4) Credit Risk
Credit risk is the risk that a company or individual will be unable to pay the contractual interest or principal or both on its debt obligations. This type of risk is of particular concern to investors who hold bonds in their portfolios. Government bonds, especially those issued by the central government, have the least amount of default risk and the lowest returns, while corporate bonds tend to have the highest amount of default risk but also higher interest rates. Bonds with a lower chance of default are considered to be investment grade, while bonds with higher chances are considered to be junk bonds. Bond rating services by credit rating agencies allow investors to determine which bonds are investment-grade, and which bonds are junk.
5) Political Risk
Political risk represents the financial risk that arises out of sudden change in government policies, political instability, change in government etc. Political factors can affect the value of securities up to a great extent. Change in ruling party and all other similar factors have a great effect on the market.
6) Market Risk
This risk is also referred to as market volatility. It is the day-to-day fluctuations in a stock's price. This may follow the movement of the index or affect the index movement. Normally a bull market sees good performances and a bear market sees the prices of securities in a downtrend. However, day to day volatility is also common. Although the risk is high, the returns are also consequently high for volatile securities.
These are the various type of risks associated with the market. For having a successful portfolio it is very important to keep in mind the various type of risks involved. The risk may appear to be very small but can have a large effect on the market. You should follow the basic trading fundamentals and keep some promises to become a successful trader.