SIE Prep - Risk Matrix

Overview of Risks Associated with Financial Products

  • Introduction of a risk table, which encapsulates various risks linked with different financial products.

  • The table contains data on default risk and other categories relevant to bonds and returns.

1. Corporate Bonds

  • Characteristics:

    • Trades in eighths (e.g., price increments).

  • Risk Factors:

    • Default Risk: Measured by credit ratings (AAA, AA, A, BBB - investment grade; below BBB - speculative).

    • Interest Rate Risk: Risk of bond prices falling due to rising interest rates.

    • Reinvestment Risk: Risk associated with reinvesting coupon payments at lower interest rates when market rates decline.

    • Call Risk: Issuers may call bonds when interest rates drop to reissue at lower rates.

    • Inflation Risk: Risk that inflation will erode purchasing power; especially critical for fixed income securities.

2. Municipal Bonds (Munis)

  • Similarities with Corporate Bonds:

    • They also incur default, interest rate, reinvestment, call, and inflation risks.

  • Additional Risk:

    • Legislative Risk: Potential legislative changes that could impact the tax-free nature of municipals, appealing primarily to affluent investors.

3. Treasury Bonds (T-Bonds)

  • Trading Characteristics:

    • Trade in increments of 30 seconds.

  • Risk Assessment:

    • Minimal or no default risk (considered very safe).

    • Interest rate risk and inflation risk exist, with no call risk for T-bonds.

4. Treasury Inflation-Protected Securities (TIPS)

  • Features:

    • Par values adjusted with inflation measured by the Consumer Price Index (CPI).

    • They come with less interest rate risk compared to other bonds because they adjust for inflation.

  • Risk Exposure:

    • They have reinvestment risk due to the periodic payments received.

5. Treasury Bills (T-Bills)

  • Nature:

    • Known as the "risk-free rate of return".

    • Generally, no significant risks associated.

  • Usage: Commonly utilized as a safe place to “park” investment capital.

6. Preferred Stocks

  • Characteristics:

    • Generally described as fixed income, but the risk is categorized under business risk (i.e., the entity's ability to pay dividends).

  • Risk Types:

    • Interest rate risk, reinvestment risk, call risk, inflation risk.

    • Variants include convertible and adjustable preferred stocks.

7. Common Stocks

  • Differentiation: Not subjected to typical bond risks (e.g., default, interest rate, reinvestment, call, inflation risks).

  • Risk Aspects:

    • Systematic Risk: Market-wide risk that cannot be diversified away.

    • Non-Systematic Risk: Specific to the company or sector, which can be mitigated via diversification.

    • Lack of Political or Currency Risks: Since they trade within a stable economy's context.

8. American Depositary Receipts (ADRs)

  • Nature: Represents foreign securities traded in U.S. markets, packaged and sold to investors.

  • Risk Evaluation:

    • Lacks bond risks but is still subject to:

    • Systematic risk

    • Non-systematic risk

    • Political risk due to foreign investment exposure.

    • Currency risk affects investments in foreign markets significantly.

Conclusion

  • The speaker emphasizes the differences in risks associated with various securities and the importance for investors, especially those preparing for the SIE exam.

  • Encourages audience engagement with a Q&A session and to consider the implications of the content discussed.