Understanding Products and Their Risks
Products and risk
Candidates should map each product to its cash-flow and risk profile. Common stock offers voting and a residual claim; preferred stock ranks ahead of common for dividends and liquidation but is still equity and behaves like a credit instrument. Debt includes Treasury, agency, municipal, and corporate bonds; municipal interest is generally federally tax-exempt, while capital gains remain taxable. Derivatives include options (buyer has a right, writer has an obligation) and futures (both parties obligated). Packaged products include mutual funds (priced at next NAV), ETFs (intraday), closed-end funds (market price, possibly premium/discount), UITs (fixed portfolio), and hedge funds (accredited investors). Annuities are tax-deferred insurance products. Risks include systematic/market, unsystematic, credit, interest-rate, inflation, liquidity, currency, call/prepayment, reinvestment, political/regulatory, and opportunity cost.
Traps: Zero-coupon bonds have no reinvestment risk but high interest-rate risk; TIPS adjust principal for inflation; preferred dividends are not guaranteed; mutual fund orders do not fill intraday; closed-end funds can trade above or below NAV; options writers receive premium and accept obligation.
Worked example: A bond pays a 5% coupon, but market yields rise to 6%. New bonds are more attractive, so the older 5% bond must trade at a discount to par to raise its yield to the market level. Bond prices and yields move inversely.