Chapter 12, Problem 1LO

Describe the various types of risks to which investors are exposed, as well as the sources of return.

Summary Introduction

To discuss: The various types of risks that investors are exposed to and the sources of returns

Explanation of Solution

Being in the market, investors are exposed to various risks which are as follows:

• Business Risk: Business risk is the risk linked with the specific business in which the investor has invested. It includes the risk of business failure due to poor management, decreased profit and sales, and others.
• Financial risk: The risk related to the firm’s mix of equity and debt capital and its capability of repaying its debt and other financial obligations, is known as a financial risk.
• Purchasing Power risk: It is the risk that an investor is exposed due to fluctuations in the price levels that influence the investment returns.
• Market Risk: Market risk is related to the behavior of the investors in the market that leads to fluctuations in the security’s price.
• Event Risk: Event risk is associated with the major events that suddenly take place and affect the investment’s value.
• Interest rate risk: Interest rate risk is the risk related with the fluctuations in the interest rate that affects the returns of the fixed income security.
• Liquidity risk: The inability to sell the investment at a reasonable price is known as liquidity risk. 

Followings are the different sources of returns for the investors:

• Current Income: Current Income is the income or the return an individual is able to earn at regular interval of time. For example, dividends, rent from a building, bond’s interest, and others.
• Capital Gain: Capital gain is the gain that is attained due to an upsurge in the value of the investment. Such an investment can be sold at a profit.
• Earnings Interest on interest: This is another source of earning where the investors reinvest their earned interests and get returns from it.