Business investments usually carry different risks. Two types of risk found in the economic market place are systematic and non-systematic risk. Systematic risk is also known as market risk; it includes the risk involved in the overall economy or investment market. Non-systematic risk usually relates to a single company or a single type of investment. Different types of risks affect how business owners approach investment decisions.
Interest Rate Risk
Interest rate risk occurs when changes in the overall economic market affect specific types of investments. This type of risk commonly affects the bond market. As interest rates increases, new bonds must be issued with higher interest rates to attract investors. This drives down the value of old bonds issued at lower interest rates. The opposite occurs when interest rates lower in the overall bond market.
Inflation occurs in an economy when a huge some of money can afford too few goods. Rising economic inflation reduces the purchasing power of an investor’s money. Not only can investors purchase fewer investments, investors will also face lower returns on current investments as inflation eats away at the overall return percentage of investments. To offset inflation risk, investors will demand higher interest rates, which may create an imbalance in the investment market.
Currency risk occurs when business investments in foreign companies or economic markets increases or decreases in value based on the current currency exchange rate. Investors may also face currency risk if they invest money in mutual funds or money markets that offer international investments. Currency risk may be mitigated by investing in multiple international markets at one time.
Liquidity risk is the inability to buy or sell investments quickly in the open market. This risk may also occur when investors are unable to buy or sell investments at a reasonable price. Investors often face higher liquidity risk in over-the-counter markets and small-cap stocks. This risk is higher because investments in these markets usually have lower investment demand.
Political risk occurs in business investments when domestic or international regions make significant changes to the business environment. Common political risks include increased government regulation, heavy taxation rates, military coups or terrorist attacks and war. This risk may create significant disruptions to international markets where free enterprise conditions may be less favorable.
Company risk is a one of two types of non-systematic risk. This type of risk occurs when companies make bad business decisions, struggle to maintain positive cash flows, or continually produce goods or services that cannot meet consumer demand. Company risk may be difficult to assess as negative situations can be hidden inside a company’s operations.
The second most common non-systematic risk relates to a company’s credit. Credit risk occurs when companies are unable to repay investors or pay out investment contracts, such as fixed annuities. Credit risk also relates to bond issuers who cannot pay interest or principal at maturity date of the bond.