The relationship between risk and return is a fundamental trade-off in Finance. When investors expect macroeconomic conditions to expand, they tend to accept extra risk in investments because they expect higher returns and low volatility. Expansionary macroeconomic conditions influence investment decision making and make investors accept extra investment risk in the expectation of being adequately compensated with higher returns. In this aspect, risk is an inherent element of investment returns and is defined as the possibility of defaulting in one’s investment objectives because of return uncertainty about the expected benefits from an investment.
There are certain risks associated with trading on the stock market.
Market risk is associated with the short-term losses in the stock market. These losses can occur as a result of (1) equity risk – associated to stock price changes, (2) interest rate risk – associated to interest rates changes, (3) currency risk – associated to foreign exchange rates changes and (4) commodity risk – associated to commodity price changes. Traders and portfolio managers identify and reduce their risk exposure on a tactical level with a series of risk metrics. On a strategic level, organizations apply risk limits to manage market risk.
Systematic risk is associated with the economic and financial system and its effect is pervasive throughout the economy. The value of investments may depreciate over a given time period because of economic changes that greatly influence the stock market. To anticipate market risk, traders and portfolio managers employ asset allocation and diversification techniques in order to offset the losses of one asset class by gains in another in the same portfolio. Examples of systematic risk include changes in interest rates, changes in taxes, changes in exchange rates, the economic growth rate, actions by the Federal Reserve and military or political actions. Systematic risk cannot be diversified.
Unsystematic risk, also referred to as specific risk, is associated with the characteristics of a type of asset, or a specific industry or company. Examples of unsystematic risk include labor strikes, rise of new competitors, poor management decisions and poor service or product quality. How varying sales revenues affect the profitability of a firm and its ability to cover its liabilities is subject to a number of firm-specific factors such as how sensitive expenses are to changing sales and how much debt a firm has.
This brings risk classification to business risk that refers to the uncertainty of income cash flows and asset prices caused by the nature of a firm’s operations. For instance, in retail food industry sales and earnings are typically more stable over time than in the auto industry where sales and earnings fluctuate dramatically. Hence, the more certain the firm’s income flows, the more certain the investment returns because the undertaken risk is lower. Business risk is managed with a focus on achieving a high return on investment on a long-term horizon.
Financial risk is the risk associated with the uncertainty introduced by the method by which the firm finances its assets. For instance, if a firm finances its assets only with common stocks, then the risk incurred is simply business risk. If instead, it borrows money to finance its assets, it pays interest to its creditors prior to providing income to its stockholders, which increases the stockholder’s uncertainty of returns.
Liquidity risk is the risk incurred when an investor is not able to sell an asset for a fair market value. When investors acquire assets, they expect that they will mature or that they will be able to sell it to someone else at a higher price. In either case, investors expect to be able to convert the value of the asset into cash and to use the proceeds for current or future consumption. In this aspect, the more difficult the conversion is, the greater the liquidity risk. For instance, US T-bills have no liquidity risk because they can be bought and sold instantly at their quoted price. On the contrary, real estate pieces, antiques or foreign securities incur high liquidity risk.