In 2022, long-term U.S. Treasury bonds, which the market treats as free of default risk, fell further in price than the broad stock market as interest rates climbed. Being safe from one risk does not make an investment safe from every risk. On the exam, you earn points by naming the exact risk a question describes.
Risk is the chance that an investment gives you a different result than you expected, usually a worse one. A representative can't match a product to a customer without knowing which risks the product carries. Financial Industry Regulatory Authority (FINRA) Rule 2111 lists risk tolerance and liquidity needs as part of a customer's investment profile. Regulation Best Interest (Reg BI) requires a broker-dealer to understand the potential risks, rewards and costs of anything it recommends.
You need to recognize eleven risk types: capital, credit, currency, inflationary (purchasing power), interest rate, reinvestment, liquidity, market (systematic), non-systematic, political and prepayment risk. Each one answers a different question about what could go wrong.
Common mistakes
- Thinking trading in dollars protects you: An ADR still carries currency risk. In the euro example, the share stayed at €40, yet the ADR fell from $50 to $44.
- Answering "diversification" for a market-wide drop: A recession or broad crash is systematic risk. The answer is index puts or asset allocation, not more stocks.
- Reading "guaranteed" as "riskless": The U.S. guaranty on Treasuries and GNMA securities removes only credit risk. Interest rate, reinvestment and prepayment risk all remain.
Bottom line
- Capital risk is losing principal; neither SIPC nor FDIC covers a decline in market value.
- Ratings grade credit (default) risk; BBB or Baa and above is investment grade.
- Treasuries and GNMA carry U.S. full faith and credit; GSE and corporate debt do not.
- Rising rates cut bond prices most for long maturities, low coupons and zeros; duration measures that sensitivity.
Exam shortcut
When a question describes a loss, start by naming what caused it: Rates going up means price risk. Rates going down means call, prepayment and reinvestment risk. A stronger dollar means currency risk. Rising prices mean purchasing power risk. No buyer means liquidity risk. A government action means political risk. One company means non-systematic risk. Everything falling means systematic risk. Then pick the tool. For one company, diversify.
The full lesson (about 4,695 words, 31 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- B11
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