Glossary

Counterparty risk is the risk that the person or institution with whom you have entered a financial contract -- who is a counterparty to the contract -- will default on the obligation and fail to fulfill that side of the contractual agreement.

In other words, counterparty risk is a type of credit risk. Counterparty risk is the greatest in contracts drawn up directly between two parties and least in contracts where an intermediary acts as counterparty.

For example, in the listed derivatives market, the industry's or the exchange's clearinghouse is the counterparty to every purchase or sale of an options or futures contract. That eliminates the possibility that the buyer or seller won't make good on the transaction.

The clearinghouse, in turn, protects itself from risk by requiring market participants to meet margin requirements. In contrast, there is no such protection in the unlisted derivatives market where forwards and swaps are arranged.

The risk that the level of claims and related expenses will exceed current premiums plus reserves allocated for their payment.

Interest-rate risk describes the impact that a change in current interest rates is likely to have on the value of your investment portfolio.

You face interest-rate risk when you own long-term bonds or bond mutual funds because their market value will drop if interest rates increase.

That loss of value occurs because investors will be able to buy bonds with a new, higher interest rate, so they won't pay full price for an older bond paying a lower interest rate.

The risk that, due to changes in interest rates, investment income will not meet the needs of policy commitments. This risk can be reduced by effective asset/liability matching.

Market risk, also known as systematic risk, is risk that results from the characteristic behavior of an entire market or asset class.

One example of this type of risk is that the market prices of existing bonds generally fall as interest rates rise because investors are not willing to pay par value to own a bond that pays less interest than other bonds available in the marketplace.

So if you wanted to sell your existing bonds, you would probably have to settle for less than you paid to buy them.

Asset allocation is generally considered an antidote for market risk, since if your portfolio includes multiple asset classes it tends to be less vulnerable to a downturn in any one class.

Nonsystematic risk results from unpredictable factors, such as poor management decisions, successful competitive products, or suddenly obsolete technologies that may affect the securities issued by a particular company or group of similar companies.

Portfolio diversification, which means spreading your investment among a number of asset subclasses and individual issuers within those subclasses, can help counter nonsystematic risk.

The risk that, for a particular group of policies, premiums will not be sufficient to meet the level of claims and related expenses.

Reinvestment risk occurs when you have money from a maturing fixed-income investment, such as a certificate of deposit (CD) or a bond, and want to make a new investment of the same type.

The risk is that you will not be able to find the same rate of return on your new investment as you were realizing on the old one. In fact, the return could be significantly lower, based on what's happening in the economy at large, though it could also be higher.

For example, if a bond paying 6% interest matures when the current rate is 4%, you must settle for a lower return if you buy a new bond unless you're willing to buy one of lower quality.

One way to limit reinvestment risk is by using an investment technique known as laddering, which means splitting your investment among a number of bonds or CDs that mature gradually over a series of years.

That way only part of your total investment will mature and have to be reinvested at any one time.

Risk is the possibility you'll lose money if an investment you make provides a disappointing return. All investments carry a certain level of risk, since investment return is not guaranteed.

According to modern investment theory, the greater the risk you take in making an investment, the greater your return has the potential to be if the investment succeeds.

For example, investing in a startup company carries substantial risk, since there is no guarantee that it will be profitable. But if it is, you're in a position to realize a greater gain than if you had invested a similar amount in an already established company.

As a rule of thumb, if you are unwilling to take at least some investment risk, you are likely to limit your investment return.

The capital resources that would be needed in a worsening economic environment (same as "Target Capital").

The capital resources which an insurance company currently has, in relation to the resources that would be needed to deal with a moderate loss scenario. This scenario is based on historical experience during an average recession and adjusted to reflect current conditions and vulnerabilities. The risk-adjusted capital ratio #1 is a proprietary ratio developed by TheStreet.com Ratings, Inc.

The capital resources which an insurance company currently has, in relation to the resources that would be needed to deal with a severe loss scenario. This scenario is based on historical experience of the postwar period and adjusted to reflect current conditions and the potential impact of a severe recession.

When you evaluate an investment's risk-adjusted performance, you aren't looking simply at its straight performance figures but at those figures in relation to the amount of risk you took (or would have taken) to get the return the investment produced.

One method is to investigate the investment's price volatility over various periods of time, including different market environments.

For example, you might consider how far the price fell in the most recent bear market against its price in a bull market, or how it performed in a recent market correction. In general, the greater the volatility, the greater the risk.

However, many analysts believe that looking exclusively at past performance can be deceptive in evaluating the risk you are taking in making a certain investment, since it can't predict what will happen in the future.

A ratio originally developed by the International Committee on Banking as a means of assessing the adequacy of an institution's capital in relation to the amount of credit risk on and off its balance sheet. (See also "Risk-weighted Assets.")

When you buy a US Treasury bill that matures in 13 weeks, you're making a risk-free investment in the sense that there's virtually no chance of losing your principal (since the bill is backed by the US government) and no threat from inflation (since the term is so short).

Your yield, or the amount you earn on that investment, is described as risk-free return. By subtracting the risk-free return from the return on an investment that has the potential to lose value, you can figure out the risk premium, which is one measure of the risk of choosing an investment other than the 13-week bill.

Risk management is a set of strategies for analyzing potential risks and instituting policies and procedures to deal with them. The work of assessing the possibilities, setting priorities, and finding cost-effective solutions is also described as business continuity planning.

In a business environment, some risks, such as economic pressures or technology meltdowns, are universal while others are unique to a particular venture or physical location.

Large companies may use a combination of strategies to manage risk, including buying insurance, creating redundant systems, diversifying physical locations or core businesses, and establishing other hedges.

For an individual investor, risk can be managed in several ways: insuring at least a portion of your portfolio, allocating your assets across classes, diversifying your holdings, and hedging with derivative products.

A risk premium is one way to measure the risk you'd take in buying a specific investment. Some analysts define risk premium as the difference between the current risk-free return -- defined as the yield on a 13-week US Treasury bill -- and the potential total return on the investment you're considering.

Other measures of risk premium, which are applied specifically to stocks, are a stock's beta, or the volatility of that stock in relation to the stock market as a whole, and a stock's alpha, which is based on an evaluation of the stock's intrinsic value.

Similarly, the higher interest rates that bond issuers typically offer on bonds below investment grade may be considered a risk premium, since the higher rate, and potentially greater return, is a way to compensate for the greater risk.

Some investors and financial analysts try to estimate the risk an investment poses by speculating on how much the investment is likely to increase in value as opposed to how much it could decline.

For example, a stock priced at $50 that analysts think could increase to $90 or decrease to $30 has a 4:2 risk ratio, because they estimate the stock could go up $40 but down $20.

Critics point out that it is impossible to provide an accurate estimate of future prices, rendering risk ratios meaningless.

Risk tolerance is the extent to which you as an investor are comfortable with the risk of losing money on an investment. If you're unwilling to take the chance that an investment that might drop in price, you have little or no risk tolerance.

On the other hand, if you're willing to take some risk by making investments that fluctuate in value, you have greater risk tolerance. The probable consequence of limiting investment risk is that you are vulnerable to inflation risk, or loss of buying power.

The sum of assets and certain off-balance sheet items after they have been individually adjusted for the level of credit risk they pose to the institution. Assets with close to no risk are weighted 0%; those with minor risk are weighted 20%; those with low risk, 50%; and those with normal or high risk, 100%.

Systematic risk, also called market risk, is risk that's characteristic of an entire market, a specific asset class, or a portfolio invested in that asset class.

It's the opposite of the risk posed by individual securities in a class or portfolio, also known as nonsystematic risk. The predictable impact that rising interest rates have on the prices of previously issued bonds is one example of systematic risk.

A target risk fund is a fund of funds that maintains a specific asset allocation in order to provide an essentially level exposure to investment risk.

You may find a target risk fund attractive if you want a professional manager to keep your portfolio aligned with your risk tolerance as you pursue specific investment goals.

Target risk funds are generally available with conservative, moderate, and aggressive portfolios, and some mutual fund companies offer even more finely tuned approaches.

Like other funds of funds, the fees you pay for a target risk fund may be higher than you would pay to own each of the individual funds separately. However, these fees pay for an additional level of professional oversight.