The overall uncertainty of returns has several components.

• Default risk on a financial security is the chance that the issuer will fail to make the required payment. For

example, a homeowner may fail to make a monthly mortgage payment, or a corporation may default on

required semiannual interest payments on a bond.

• Inflation risk occurs when investors have less purchasing power from the realized cash flows from an

investment due to rising prices or inflation.

• Diversifiable risk, also known as unsystematic risk, occurs when investors hold individual securities or

smallish portfolios and bear the risk that a larger, more well-rounded portfolio could eliminate. In these

situations, investors carry additional risk or uncertainty without additional compensation.

• Non-diversifiable risk, or systematic risk, is what remains after portfolio diversification has eliminated

unnecessary diversifiable risk. We measure non-diversifiable risk with a statistical term called beta.

Subsequent chapters on risk and return provide a more in-depth discussion of beta.

• Political risk is associated with macroeconomic issues beyond the control of a company or its managers.

This is the risk of local, state, or national governments “changing the rules” and disrupting firm cash

flows. Political risk could come about due to zoning changes, product liability decisions, taxation, or even

nationalization of a firm or industry.