Types of risk – Part 2

Social risk

Social risk refers to the possibility that a segment of society will institute boycotts, litigation, publicity campaigns, or lobbying efforts against a company due to its social policy or business practices. The actions of society can negatively affect that company’s performance. Tobacco, energy, gaming, and weapons companies often face this type of risk, as do companies that face environmental or discrimination concerns.

Example(s): A large oil company ships crude oil overseas in giant tankers. One night, while pulling into port, the tanker’s captain miscalculates and crashes into another tanker, opening a hole in his own ship. Millions of gallons of oil spill into the sea and wash up on the shore. The cleanup effort costs millions of dollars, paid by the country’s taxpayers. The oil corporation refuses to reimburse the government for the expense. In reprisal, the country’s driving population boycotts the oil company’s service stations for the next several years, causing a great economic loss to the company.

Reinvestment rate risk

Reinvestment rate risk refers to the possibility that you will have to reinvest funds at a lower rate of return than the investment originally earned.

Example(s): Your six-year, 9 percent interest CDs mature. You would like to reinvest the money in new CDs. At that time, however, CDs are earning only 5 percent interest. You must either accept a lower return or find an alternative investment.

Exchange rate or currency risk

Exchange rate or currency risk arises because of fluctuating foreign exchange rates. These fluctuations may affect the value of foreign investments or profits when converting them into U.S. currency. If you have investments denominated in a foreign currency, they may rise in value if the dollar falls; conversely, if the value of the dollar rises, the corresponding drop in the relative value of the foreign currency could cause your investments to lose value.

Political risk

Political risk refers to possible changes in the government or legal environment. For example, taxes may rise, tariffs may be imposed, or wages and prices may be controlled. All of these things could result in reducing a company’s profits.

What are the types of unsystematic risk? Business (or industry) and business failure risk

Business or industry risk refers to the risk associated with a particular company or industry. Business risk can be caused by changes in a company’s sales due to operating problems, such as a strike, an unfavorable outcome of litigation, or technical obsolescence. Industry-specific risks arise because some industries are inherently more uncertain than others. They may face greater risks due to accidents, product liability, or the innovative nature of their business. For example, a company developing new drugs likely has a greater inherent risk than a company manufacturing consumer products, such as soap or shampoo.

In addition, some businesses prosper while others fail. When a business fails, stockholders--and sometimes bondholders--can lose their entire investment.

Financial, credit, or default risk

Financial or credit risk arises when a company incurs excessive debt. Put in accounting terms, financial risk is related to the company’s debt-to-equity ratio. That means the company has a high fixed obligation (interest) to pay each year. If the firm does not perform well, it may be unable to satisfy that obligation and pay bondholders or preferred stockholders. In addition, borrowing exposes the company to the risk that creditors will file legal claims against it.

Liquidity risk

Liquidity risk refers to the chance that an asset may not be easily sold, or may not receive its full market value, especially if it must be sold on short notice. For example, if a company’s stock is held by relatively few stockholders and demand for the shares is not high, one of those stockholders might have difficulty finding a buyer, which could affect the stock’s price.

Article courtesy of Forefield.Securities offered through NPB Financial Group, LLC. A Registered Investment Advisor/Broker-Dealer Member FINRA, MSRB, and SIPC