RiskMetrics - Sources of Risk
Sources of Risk
Learn why the price of stocks and bonds fluctuate
Why stocks fluctuate
Why does the price of Coca-Cola shares fluctuate every day, when the price of Coca-Cola does not? Stock and bond prices are based on expectations of future profits and returns, which are ever changing and uncertain. The price which Coca-Cola sells its products today are only a small part of what goes into the share price of Coca-Cola. Every day, traders reassess the value of Coca-Cola shares based on what they expect Coca-Cola to earn over the foreseeable future, how sure they feel about their forecasts, and just as important, what they think other market participants' views are about Coca-Cola's future.
Why bonds fluctuate
Bond prices, like stock prices, also depend on market views about the future. In contrast to stocks, however, bonds are tied more closely to views about the economy on a whole rather than the fortunes of individual companies. Since bonds pay a fixed interest rate, investors tend to focus on the interest rate, or more precisely, the yield, rather than the price of a bond. When interest rates in the economy as a whole rise, the price of a bond falls, since it pays a fixed coupon rate which is now below the market rate.
Long term bonds are riskiest
Longer maturity bonds are more sensitive to changes in interest rates, because the interest rate they pay is locked in for a longer period of time. Imagine you own a bond that pays 5% interest while the market rate is 6%. Would you rather be locked into a below-market interest rate for one year or 10 years? A 10-year bond is therefore much more risky than a 1-year bond.
Price fluctuations drive RiskGrades
RiskGrades are based on statistical analysis of historical price fluctuations of stocks and bonds (and foreign exchange rates and commodity prices). Large price fluctuations are an indication of high uncertainty, or risk. Learn more about measuring risk in the next module.