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The risk map: matching products to risks

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Each product carries two or three named risks. Diagnose from the facts, not the label.

Sort by where the loss came from

Risks are easier to tell apart when they are grouped by source rather than memorized as a list. Some come from the borrower. Credit or default risk is the chance that an issuer cannot pay interest or principal, and it is why ratings exist and why a weaker issuer must offer a higher yield. Nothing about a rating protects against anything else, which is the trap most often set with this risk.

Some come from the market as a whole. Market risk is the chance that prices fall together; the SEC notes that diversification can’t guarantee investments won’t suffer when the market drops. Interest-rate risk is the specific market risk that rising rates push the price of an existing bond down. Inflation risk, also called purchasing-power risk, is the chance that fixed payments buy less over time: it erodes a fixed rate of interest, the SEC calls it the principal concern for cash equivalents, and a longer stream of fixed payments is exposed for longer.

Some come from the plumbing. Liquidity or marketability risk is the chance that a holding cannot be sold quickly at a fair price. It has nothing to do with the issuer’s health: a perfectly sound partnership interest or a non-traded property vehicle can be entirely unsellable on a given Tuesday, while the shares of a struggling listed company trade all day.

Some come from outside the country. Currency or exchange-rate risk is the chance that a move in the exchange rate changes what a foreign holding is worth in dollars. Political or legislative risk is the chance that a government changes the rules, for example by imposing currency controls that restrict the movement of money. Both attach to what the investment is exposed to, not to who bought it.

Start with the most basic exposure: capital risk, the possibility of losing some or all of the money invested. Every investment carries some degree of risk, meaning uncertainty and potential financial loss, and investors generally expect higher returns for taking more of it. A stockholder owns part of a company and a bondholder has lent it money, and both are paid only if the company stays in business; if it fails and its assets are liquidated, common stockholders are last in line. Losing capital is different from losing income: a holding can keep paying income for years and still be worth less than was paid for it.

Exam terms

Credit (default) risk
The issuer may fail to pay interest or principal.
Market risk
Prices fall together; diversification can’t guarantee against it.
Interest-rate risk
Rising market rates push down the price of existing bonds.
Inflation risk
Fixed payments buy less over time.
Liquidity risk
The holding cannot be sold quickly at a fair price.
Currency risk
Exchange-rate moves change the dollar value of a foreign holding.

Where the loss comes from

Investment riskNamed by its source, not by the product
  • The borrowerThe issuer may not pay
    • Credit or default risk
    • Ratings measure this and nothing else
  • The marketPrices and rates move against you
    • Market risk
    • Interest-rate risk
    • Inflation risk
  • The plumbingYou cannot get out when you want to
    • Liquidity or marketability risk
    • Independent of issuer health
  • AbroadExposure outside the home country
    • Currency risk
    • Political or legislative risk
Ask what went wrong before naming the risk.

Try it: Diagnose four one-line losses without looking at the list: a bond issuer misses a coupon; a bond falls in price after a rate rise while paying every coupon on time; a partnership interest cannot be sold at any sensible price; a foreign share is flat at home but worth less in dollars. Name the risk for each, then say which one of the four a credit rating would have warned about.

The ruleMarket, interest-rate and inflation risk come from the market as a whole; credit risk from the borrower; liquidity risk from the ability to sell; currency and political risk from foreign exposure.

The closest contrast

Credit risk: the borrower.

Interest-rate risk: the market.

The distinction decides most bond risk questions. If the issuer paid everything it promised and the holder still lost money, the cause was not credit; look to rates, inflation or the inability to sell.

Worked example

An investor holds a long-dated, highly rated corporate bond and complains that it has lost value even though every payment has arrived on time.

  1. Start with the borrower. Every coupon has been paid and the rating is unchanged, so credit risk has not materialized at all.
  2. Move to the market. Market rates have risen since the bond was bought, so newly issued bonds pay more and this one must be discounted to compete. That is interest-rate risk, and its effect is larger because the bond is long-dated.
  3. Add inflation. Prices have risen faster than expected, so each fixed coupon buys less than the investor assumed it would. That is inflation risk, and it also helped push market rates up.
  4. Test liquidity separately. If the bond can still be sold at the going market price, liquidity risk has not occurred; the loss is in the price, not in the ability to trade.
  5. The diagnosis is interest-rate risk and inflation risk together, with credit risk absent. A choice naming the rating agency or the issuer’s health would be answering a question the facts never asked.

Check yourself

Try a question, then read the explanation to review the rule.

Opening your study record…

Same rule, new context

Opening your study record…

Summary

  • Credit risk is about the borrower paying; a rating measures that and nothing more.
  • Interest-rate risk hits longer-maturity fixed-rate bonds hardest; inflation risk erodes fixed payments and is the principal concern for cash equivalents.
  • Liquidity risk is about being unable to sell, and it is independent of the issuer’s health.
  • Currency and political risk attach to foreign exposure, whoever the investor is.

Related practice

Sources

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