Risk

Lesson

This lesson will discuss the various risks associated with fixed-income securities.

Practice Question #1

Which of the following risks is associated with an issuer defaulting on its interest or principal payments?

A) Credit risk

B) Interest rate risk

C) Reinvestment risk

D) Inflation risk

Select an option above to see an explanation here.

A) Credit risk is the risk that the bond issuer will default on its interest or principal payments. B) Interest rate risk is the risk that interest rate changes will negatively affect a bond's value. C) Reinvestment risk is the risk that an investor will have to reinvest the proceeds from a bond at a lower interest rate. D) Inflation risk is the risk that the purchasing power of a bond's interest payments will be eroded by inflation.

Terms

Interest rate risk:: The risk that interest rate changes will negatively affect a bond's value.
Reinvestment risk:: The risk that an investor will have to reinvest the proceeds from a bond at a lower interest rate.
Inflation risk:: The risk that the purchasing power of a bond's interest payments will be eroded by inflation.
Prepayment risk:: The risk that a borrower will pay off a loan or mortgage before its maturity date, reducing the interest income for the bondholder.
Event risk:: The risk that an unforeseen event, such as a natural disaster or regulatory change, will negatively impact the value of a bond.
Currency risk:: The risk that changes in exchange rates will negatively affect the value of a bond denominated in a foreign currency.

Practice Question #2

Which risk is associated with changes in exchange rates negatively affecting the value of a bond denominated in a foreign currency?

A) Currency risk

B) Liquidity risk

C) Event risk

D) Duration risk

Select an option above to see an explanation here.

A) Currency risk is the risk that changes in exchange rates will negatively affect the value of a bond denominated in a foreign currency. B) Liquidity risk is the risk that an investor cannot sell a bond quickly and at a fair price. C) Event risk is the risk that an unforeseen event, such as a natural disaster or regulatory change, will negatively impact the value of a bond. D) Duration risk is the risk that the sensitivity of a bond's price to changes in interest rates will increase as its duration increases.

Do Not Confuse With

Market risk:: The risk that the overall market will decline, negatively impacting the value of all investments.
Systematic risk:: The risk that affects all investments in a market or asset class, such as interest rate risk or inflation risk.
Unsystematic risk:: The risk that is specific to an individual investment, such as credit risk or event risk.

Practice Question #3

Which risk is specific to an individual investment, rather than affecting all investments in a market or asset class?

A) Systematic risk

B) Unsystematic risk

C) Market risk

D) Equity risk

Select an option above to see an explanation here.

A) Systematic risk is the risk that affects all investments in a market or asset class, such as interest rate risk or inflation risk. B) Unsystematic risk is the risk that is specific to an individual investment, such as credit risk or event risk. C) Market risk is the risk that the overall market will decline, negatively impacting the value of all investments. D) Equity risk is the risk that the value of a stock will decline due to changes in the company's financial performance or market conditions.

Historical Example

In the early 2000s, a major telecommunications company experienced a significant decline in its credit rating due to financial difficulties. As a result, the value of its bonds dropped significantly, and investors who held these bonds faced substantial losses due to credit risk.