Economic risk

Definition

Economic risk refers to the potential for an investment's value to decrease due to changes in the economic environment. This can include factors like inflation, currency fluctuations, or changes in government policy, all of which can significantly impact international and emerging market investments. Understanding economic risk is crucial for investors as it helps them assess potential volatility and long-term viability of their investments in different regions.

5 Must Know Facts For Your Next Test

1. Economic risk is often heightened in emerging markets due to less stable economic policies and greater sensitivity to global market shifts.
2. Investors can mitigate economic risk through diversification across various geographic regions and asset classes.
3. Factors like GDP growth rates and unemployment levels are indicators of economic health that can influence economic risk.
4. Emerging markets may experience rapid economic changes, leading to sudden increases or decreases in economic risk levels.
5. Understanding local economic indicators and trends is essential for assessing potential economic risks when investing internationally.

Review Questions

• How does economic risk impact investment decisions in emerging markets?
  • Economic risk plays a significant role in shaping investment decisions in emerging markets by influencing expected returns and volatility. Investors must consider factors like inflation rates, currency stability, and overall economic growth when evaluating these investments. Higher economic risk often leads to greater caution among investors, who may seek to limit exposure or adjust their strategies based on the prevailing economic conditions.
• Compare and contrast economic risk with political risk in the context of international investments.
  • While both economic risk and political risk can adversely affect international investments, they originate from different sources. Economic risk stems from fluctuations in the economy, such as inflation or changes in currency values, impacting asset values. Political risk arises from governmental actions or instability that may disrupt business operations or affect regulatory environments. Both types of risks must be assessed collectively as they can interact; for instance, poor economic conditions can lead to political unrest, compounding the overall risk landscape for investors.
• Evaluate how understanding economic risk can enhance an investor's strategy in managing a diverse portfolio that includes international assets.
  • Understanding economic risk allows investors to make informed decisions about asset allocation within a diverse portfolio that includes international investments. By recognizing potential vulnerabilities related to economic conditions in different regions, investors can strategically diversify their holdings to minimize exposure to adverse events. This knowledge enables them to identify opportunities that may arise from favorable economic trends while being prepared to adjust their strategies as necessary based on changing economic landscapes, ultimately leading to more resilient investment outcomes.

Related terms

Currency Risk: The risk of loss due to changes in exchange rates affecting international investments.

Political Risk:

The risk that political events, such as instability or changes in government, will affect investment returns.

Market Risk: The risk of losses due to factors that affect the overall performance of the financial markets.