by Christina Pomoni

Created on: September 20, 2009   Last Updated: February 27, 2011

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.

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