Investment Risk in Capital Markets 

The term risk generally refers to the volatility, or stability, of a particular security. Investments typically have an associated risk based upon their exposure to markets and the fluctuations within them. Risk is differentiated from “uncertainty” because it is measurable; therefore, investors must methodically research the securities they invest in to mitigate loss. Their research and analyses are crucial in deciding what kind of position, if any, should be taken.

Markets price securities to incorporate all available information, and react quickly to incorporate the effects of new information into the price of securities. Investors, however, can only predict future information and its effect on the pricing of securities.

 

Risk and Return 

Risk is one of the most fundamental aspects of investing and lies within the core of research. Investors seek securities that will offer a high return without losing principal investment. The investments often deemed “risky,” in many cases, are subject to greater return than those considered risk-averse. It is this concept that leads money managers to seek out risky investments that they believe will yield a high return.

Without knowing how the overall economy and its various macroeconomic factors, the company or underlying assets tied to the security, and how the investor’s own financial situation will perform and change, the investor has no way of accurately predicting the performance of any security or class of securities.

There are several kinds of risks, such as:

Systemic risk, which comprises three factors: uniqueness, interconnectedness, and size. When a company or financial institution has the aforementioned factors, they may pose a systemic risk to the market, such as AIG in 2008.

Credit or default risk refers to the risk that a company or an individual will be unable to pay the contractual interest or principal on, with respect to its debt obligation(s). This particular risk comes into play for those holding bonds. Investors’ primary concern is whether or not the company will be able to make payments that they contractually agreed upon.

Market risk is a risk that is common to all securities of the same general class and thus cannot be eliminated by diversification. This sort of risk is largely associated with stocks, bonds, and options.

See related Issues: Systemic Risk.

Continue reading about Industry Basics: Debt and Equity Securities in Capital Markets.