Risk and Tax Considerations - Investment Risk (Part 2 of 2)

Default Risk

The possibility that a bond issuer will default on a payment or that its credit rating will be downgraded. It could conceivably lead to capital risk, that is, loss of principal.

However, a more likely scenario is that an investor ends up with a missed payment.

As a result, the corporation would be considered very risky by creditors, investors and bond rating agencies alike, and it would need to issue new bonds at a very high rate in order to provide incentive to buy them. Consequently, this is bad news for investors who bought that company's securities at a lower interest rate.

Liquidity Risk
The possibility that you may not find a buyer at a fair market price at the same moment you want to sell. Stocks, bonds, options and publicly traded mutual fund shares have very little liquidity risk. Shares in direct participation plans can have a very high liquidity risk.

Political Risk
Although this risk may sound like something you would encounter when investing in less industrialized nations, but there are political risks in North America as well. In certain developing countries, there may be a risk of a regime that is antithetical to the market economy coming to power, nationalizing entire industries and expropriating the assets of foreign companies. There are also political risks associated with war and insurrection. However, even in the United States, where both major political parties espouse the benefits of capitalism, there is the risk that a specific piece of legislation or newly proposed regulation could create or outlaw an entire industry. Investors who hold tobacco stocks can tell you all about political risk. Wall Street knows all too well that terrorism can strike at any time and affect the markets.

Call Risk
Call risk is the reason why you receive a higher return on callable bonds than non-callable bonds. If a bond is callable, the issuer can buy back a current issue to reissue bonds at a lower interest rate. Essentially, issuers say, "Yes, we know this is a 10-year bond and it has only been five years, but interest rates are falling and we think we can save money if we buy back all the bonds that we sold you with a 10% coupon and issue new ones at the prevailing 6% rate. If you check the fine print, you'll see we have the right to do that."

Note that call risk is entirely restricted to bonds. In most cases, corporate rather than municipal or federal bonds are callable.

Currency Risk
The risk that the exchange rate will change to your disadvantage. In other words, if you live in the dollar zone and exchange dollars to buy an instrument denominated in yen, and the yen loses value against the dollar, then your investment will suffer when you sell it and convert the proceeds back to dollars.

Currency risk is a consideration for any enterprise doing business across borders.

For a primer on popular types of risk, as well as the relationship between risk and return refer to the tutorial Risk and Diversification.

Stock Classification Risks
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