What is risk?
In the world of finance, risk can be defined as the possibility that a return on investment will be lower than what the investor is expecting.
Financial risk can be divided into several categories, including but not limited to capital risk, basic risk, default risk, exchange rate risk and interest rate risk, among others.
Capital risk is the possibility of an investor losing all of the principal amount that he or she has invested. For instance, if you were to invest $5,000 in the stock market, your capital risk on that investment would be $5,000.
Default risk refers to the possibility of not being able to keep up with scheduled payments for your mortgage and other debt obligations. A debtor’s default risk can measured by that person’s FICO score, which helps lenders determine how likely a debtor will pay back a loan.
Exchange rate risk also can be referred to as foreign exchange risk, FX risk or currency risk. It’s the possibility that an investment’s value may change due to changes in currency exchange rates.
Similar to exchange rate risk, interest rate risk deals with changing values, although it involved interest. Interest rate risk is the possibility of an investment’s value changing due to changes in interest rates.
Interest rate risk affects the values of bonds more than it affects the value of stocks. This is because interest rates rise as bond prices fall, reducing the opportunity cost of holding a bond and making it easier for other investors to obtain greater yields by switching to investments that may reflect the higher interest rate.
Bill buys XYZ Co. stock for $15 a share, knowing that a capital risk existed that the value of his investment could drop if an event occurs that makes investors flee the stock. That event might be lower-than-expected earnings for a quarter, a change in management or a shareholder lawsuit.
In this case, XYZ’s investors lost faith in the company’s ability to post strong earnings after a hurricane hit Florida and other parts of the Southeast, a region where XYZ normally generated strong sales. Bill’s investment lost money as a result.