Market Risk - Explained
What is a Market Risk?
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Table of ContentsWhat is a Market Risk?How Does a Market Risk Work?Market Risk ExampleTypes of Market Risks FactorsVolatility and Hedging Market RiskDiversification and Market Risk Metrics for Measuring Market RiskValue-at-risk (VaR) method: Beta method:
What is a Market Risk?
Market risk refers to the risk where there is a possibility of an investor experiencing a decrease in value of an investment as a result of changes in financial market factors. Note that you cannot completely eliminate market risk through diversification. However, you can hedge against by diversifying it into assets that have no correlation with the market. Hence, another term used to refer to market risk is, systematic risk.
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How Does a Market Risk Work?
Public firms in the U.S. are obligated by the Securities and Exchange Commission (SEC) to reveal how their output and results are connected to the financial markets performance. This is for the purpose of detailing the exposure of the company to financial risk. Note that there are high chances of financial risk exposure for companies that provide investment that is derivative or foreign exchange future, compared to companies without these kinds of investments. Traders and investors use this information to help them to assess and make informed decisions as per the laid down risk management rules. Generally, there are two major categories of investment risk which are made up of market risk and specific risk. Market risk represents the overall securities markets or the overall economy. On the other hand, specific risk refers to only a section of this.
Market Risk Example
You can decide to buy a new car with a full warranty or get yourself a second-hand car without a warranty. Your choice will depend on features, mechanic knowledge, risk tolerance as well as the ability to afford it. You will come across different models of cars. Some with better performance and repairs history that is superior to others. Irrespective of which car you will end up with, there are road risks which you may experience that is not associated with the kind of car you have chosen but can have an adverse effect on your driving skills. An example of such include:
- Hitting an animal along the road
- Weather conditions
- Icy roads
- Traffic lights that are not working correctly, etc.
Types of Market Risks Factors
The commonly known types of risk market factors include the following:
- Equity risk: This refers to the risk where there is the possibility of share prices changing.
- Interest rate risk: This where there is a likelihood of interest rates fluctuating (going up or down)
- Currency risk: This refers to the possibility of foreign exchange rates changing.
- Commodity risk: This is the likelihood of a commodity's price changing. Example of such commodities includes grain or metal.
- Inflation risk: this risk refers to the risk that there is a possibility of overall price increases which in turn will weaken the value of money, hence significantly affecting investments value.
Generally, market risk consists of the unknown which happen as a result of daily life. Note that market risk is always unavoidable in all investments that are known to be risky. Market risk, in other words, it is known to be an opportunity cost where the money is put at risk.
Volatility and Hedging Market Risk
As long as there are price changes in the overall market, there will always be market risks. The price changes may occur in stocks, commodities or currencies, hence the term, price volatility. Note that since volatility rating is an annual thing, it can, therefore, be expressed in terms of percentage (e.g. 20%) or as an absolute number (e.g. $20) of the initial value. For investors to be able to guard themselves against risk and volatility, they make use of hedging strategies. Investors do this by targeting specific securities, where they buy put options so that they can protect against downside movement. For those investors who want to hedge against portfolios with huge stocks can do this by using index options.
Diversification and Market Risk
Investment diversification is the best strategy for reducing market risks. Note that due to nature, some market risks are impossible to foresee or prevent. Some of the risks that cannot be prevented or foreseen but does affect investment when they strike are those that are related to natural disasters such as:
- Volcanic eruptions
There are also other sources of market risks such as recession, political instability, terrorist attacks, and trade embargoes. The best strategy of reducing market risk is by diversifying portfolios. For a portfolio to be regarded as a well-diversified portfolio, it must include:
- Securities from different industries
- Asset classes
- Countries with varying degrees of risk
In general, the chances of each investor facing market risks due to economic indicators such as normal business cycle and recessions are high. The risk can be the overall market or specific market investment. As an investor, you need to know that due to market efficiency, there will be no compensation for any additional risk that you may incur in case you fail to diversify your portfolio. This is important for investors with one large holding of the stock.
Metrics for Measuring Market Risk
There are two major models that analysts and investors can use to measure market risks. They are as follows:
Value-at-risk (VaR) method:
This is a method that quantifies portfolios or stock through statistical risk management as well as the possibility of loss taking place. To limit the VaR method, certain assumptions must be applied. For instance, VaR is of the assumption that the portfolios makeup, as well as content that is subject to measurement, remains unchanged for a specified time. Note that this is only favorable where short-term investments are involved. However, it may provide inaccurate measurements when it comes to long-term investments.
This is another method that investors and traders can use to measure market risks. The beta method is used to measure a portfolio of security's market risk or volatility in comparison to the overall market. Note that this method is mostly used when measuring capital asset model where investors and traders apply it when calculating the assets anticipated returns.