Introduction
Market risk is the other name given for systematic risk.
This is the risk from not performing well, but it is also due to reasons related to the general performance of the whole market.
While specific risk affects specific companies or industries, market risk affects the overall market or class of assets.
It is induced by a change in interest rates, an economic fluctuation, political change, or even market sentiment.
Therefore, changes in interest rates easily influence the price of any financial security: stocks, bonds, commodities, and currencies.
It is thus the most crucial factor of necessity that investors, portfolio managers, and financial institutions must understand and control market risk in order to reduce the possible loss and achieve maximum returns.
In the article to come, we will write about what market risk is, how one measures it, the various kinds of market risk, techniques for managing it, the regulatory framework, and how market risk compares to the special kind of risk.
We will also address practical examples of market risk and how it impacts investors.
What is Market Risk?
Market risk is considered the possibility of loss in an investment or portfolio due to adverse movements of market factors,
which include alterations in asset prices and interest rates or commodity prices; exchange rates among others that affect general macroeconomic market conditions.
Thus, market risks are systemic but not specific or firm-specific/sector-specific types of risks where the diversification or elimination through hedging is practically impossible.
For instance, in a financial crisis, the whole stock market may decline irrespective of the performance of individual companies.
For example, a change in interest rates as announced by a central bank could influence the overall valuation of the bond market.
Therefore, a scheme in measuring and managing market risks is vital to proper portfolio management.
Types of Market Risk
Market risk can be categorized based on the basic factors that initiate it. Among the most common types of market risks are the following:
1. Equity Risk
Movements in the stock prices represent equity risk.
The equity risk essentially reflects the performance of the stock market, thereby influencing the value of an individual stock or a portfolio of equity indices.
Some of the determinants of equity risk include company earnings, investor sentiment, economic conditions, and geopolitical events.
Equity holders suffer from highly severe losses mainly because of extremely sharp declines in the quotations of equities or even just a correction in the market.
Example
Whenever a company’s stock price falls drastically in value because of some bad earnings report or simply as a result of a general fall in the market, then those investors holding that stock will bear the loss in value of their investment.
2. Interest Rate Risk
Interest-rate risk is loss resulting from changes in interest rates.
This is one of the key risks that bonds and fixed income investors are exposed to, and clearly, changes in interest rates will directly have an effect on the price or yield of the bond.
Increasing interest rates mean that existing bonds will drop in value, and decreasing interest rates will make them rise.
Such may create quite a dramatic effect for industries or organizations that are highly sensitive to movements in the interest rate level, such as real estate and utilities.
For example: in case the central bank raised the interest rates, the price of long-term bonds may fall since newly issued bonds that have a higher yield are available and this lowers the attraction of bonds whose yields have now become relatively low.
3. Currency Risk (Foreign Exchange Risk)
This is actually the risk, even more particularly called currency risk, and refers to variations in the rate of foreign exchange.
Hence, for instance, an international investor or multinational firm and others trading in a foreign currency can have an increased change in their profits of a foreign investment or costs;
in carrying on an international business by variations of currency rates between one country’s currency and another’s.
For example
an American investor owning shares in a European company; if the euro is appreciating against the dollar, the stock of the European company will be going down in terms of dollar though the company is earning its money.
4. Commodity Price Risk
This would relate to commodity price risk, or changes in oil prices, gold, agricultural product, and metals, which could directly affect profitability when companies produce, supply, or consume commodities.
For example, the change in the prices of crude oil would affect oil companies, airlines, and industries using high energy costs.
Example
The rising oil prices could increase the operating cost for the transporters and, consequently lead to decreased profitability.
5. Political and Geopolitical Risk
Political and geopolitical risks are the changes in government policies, political instability, or international conflicts.
These risks can impact the overall market and specific sectors significantly.
For example
the imposition of trade tariffs, sanctions, or changes in regulation can cause a lot of market volatility, particularly in industries that are sensitive to international trade.
Example:
An imposition of certain controls of a government over a sector or imposition of sanctions on any country may reduce the stock values of the enterprises which are correspondingly affected by that policy.
Market Risk Calculation
Market risks have various means of measurement.
Often, investors and financial institutions compute through quantitative models and tools, their portfolio against movements in markets.
Some common approaches to risk measures are outlined as follows:
1. Value at Risk (VaR)
The value at risk method is the primary principle, subscribed to by many market players, in assessing market risk.
Value at Risk, in a certain investment or portfolio, is hence the amount of loss which might happen over a certain period, provided a distinct level of confidence.
For instance, a 1-day VaR of $1 million at 95% confidence level would mean there is a 95% probability that the portfolio will not decrease by more than $1 million over one trading day.
The methodology to be used for the calculation of VaR may be obtained from historical simulation, variance covariance, and Monte Carlo simulations.
All three are so designed as to have an approximation about the loss distribution that is gotten using statistical models as well as past data.
2. Standard Deviation (Volatility)
This is the measure for the amount of dispersion in returns around the mean. In other words, this is the variation in the value of an asset or a portfolio over time.
The higher the standard deviation is, the more risk and volatility in prices occur.
Standard deviation is generally used in the evaluation of overall risk of one single asset or in any portfolio.
3. Beta
Beta simply communicates that the percentage of the price of a certain asset or portfolio changes when there is a movement in the general market.
If an asset has a beta of 1, it fluctuates on the market-if it’s greater than 1, it’s more volatile than the market.
Any beta of less than 1 would imply that the asset in question has lower volatility compared to the market.
Beta is used quite extensively for equity risk measurement and a comparison technique to estimate market risk among different stocks or portfolios.
4. Stress Testing and Scenario Analysis
The basic idea behind these techniques is the study of how extreme events – either market-specific financial crisis or geopolitical issues- have impacted the overall portfolio performance.
The technique in this case in the scenario analysis, is used by analyzing how the portfolio performance will be if the specified sequence of scenarios occurs.
These include the extreme changes that occur in the market environment, increasing market fluctuations, and interest rates among others.
In this regard, such techniques enhance the understanding of the rare events which become possible causes to extremes.
Risk Management Techniques
Effective management of risk can be a decisive element to dampen the blow of market risk to investments.
Among the many vital techniques of diversification, some include:
1. Diversification
This helps to reduce more market risk for the investor by investing in different classes of assets and sectors and at different geographical locations.
A diversified portfolio may eventually bring the overall impact of any upward or downward movement of a market onto an investment, thereby reducing that impact.
In the case of equities, bonds, and commodities, this balance would balance the respective risks associated with them.
2. Hedging
Hedges are used in hedging strategies targeted towards protection of the likely loss that will occur from the probable direction change of a related asset or financial instrument.
Options, futures contracts, or swaps may be used based on an understanding of investor expectation regarding the probable direction of the market.
Hedging decreases the risk in the market but it is at a cost and the residual risk is never completely eliminated.
3. Asset Allocation
It refers to the division of a portfolio across various asset classes like equities, bonds and cash equivalents which is based on a risk tolerance the investor has of his investment objectives.
The amount of each kind of asset class could be adjusted accordingly so that its market risk decreased and there can be balance seen between risk as well as a return.
4. Measures of Risk-Adjusted Return
The risks-adjusted returns measures include Sharpe ratio or Sortino ratio.
These measure allows the investors to evaluate return on an investment against the risk level assumed.
These measurements also take into account volatility or downside risk of an asset and provide a more complete picture of the return that it can offer.
Market Risk Regime
Market risk is regulated through financial authorities and institutions to control the pulsation in the financial markets.
All types of regulatory frameworks are used for controlling market risk.
1. Basel III:
Basel III is a system of regulation globally by the Basel Committee on Banking Supervision;
aimed at enhancing the requirements and supervisory measures apart from risk aggravation against the banks.
Market risk, under Basel III, has norms pertaining to capital adequacy, stress testing, and liquidity management related to countering dangers that threaten to reach financial institutions’ way.
2. SEC
It is a US institution which oversees all of its financial markets so that such practices do not mislead the investors wrongly by manipulation and fraud.
In case of a public firm, the rules impose market risk disclosure and risk management requirements.
3. RBI
RBI offers guidelines in India about the market risks of managing in the Indian banking sector.
The RBI also provides policies related to capital adequacy, liquidity, and risk management with the objective of negating the effect of market shock on institutions.
Market Risk vs. Specific Risk
Market risk or systematic risk is very much different from specific risk that is often called as unsystematic risk in the following ways:
Market Risk
is another component of the no diversifiable risk.
These are caused due to factors such as economic change, interest rates, inflation, or political instability.
Specific Risk
arises with individual companies, industries, or sectors. Diversification can minimize or remove this risk because the performance of one company or sector may not represent the overall performance of the market.
Examples of Market Risk
1. 2008 Financial Crisis
The market risk got apparent representations post the 2008 global financial crisis when the stock markets all-sided reflected the great slump in the stock market;
because subprime mortgage defaults, financial institutions’ liquidation, and global liquidity crunches had already occurred across the world markets and stored massive losses collectively.
2. COVID-19 Pandemic
In 2020, a widespread market crash occurred due to the global pandemic COVID-19.
The pandemic, captive in ambiguity about the covid virus, the government lockdowns and overall economic effects, had all major effects for the risk factor in markets, due to highly liquid assets placements.
Conclusion
The above-discussed risks are one form of inherent risk that an investment may take. It operates at the general market level, which affects every aspect of the asset classes and is therefore impossible to avoid.
Both the investors and the financial institutions feel that this is the need of the hour-to know its types, and the way to measure and control market risk.
VaR, standard deviation, and beta help in judging and quantifying market risk. Diversification, hedging, and asset allocation can reduce the effects of market risks, and these can be done by maintaining an
Thus, with a view to the incorporation of best practices to handle risks, and the knowledge about the regulatory framework in place, the investors take market risk quite easily, and the main protection their investments have are then adverse market movements.
Frequently Asked Questions
1. What are the main market risks?
Risks in the market consist of equity, interest rate, currency, commodity, and geopolitical risks, resulting most often in significant losses that primarily occur in stock markets, interest rates, foreign exchange rates, commodity prices, political chaos.
2. How to calculate market risk exposure?
Use measures such as VaR, Beta, or Standard Deviation: the above measures may use VaR, Beta, or standard deviation of returns to compute and quantify the market risk.
Value at Risk is the measurement of expected loss in an asset or a portfolio for a specific time period, employing a defined level of confidence.
Beta evaluates the responsiveness of an asset regarding general movement in the market while standard deviation refers to volatility in returns.
3. What is a market risk model?
Market risk modelling is the process of computing risks that occur in the markets or the changes that occur in these markets.
Most basic kinds of risk models consist of a given Historical Simulation Model, Variance-Covariance Model, and the Monte Carlo simulation.
These statistical models calculate likely losses due to market fluctuations around an asset or portfolio.
4. What are 3 ways to reduce risk?
Diversification:
You can minimize the adverse effects of unfavorable market movements in your portfolio by spreading investments over different asset classes, sectors, and geographies.
Diversification tends to reduce overall risk because various assets tend to respond differently to market events.
Hedging:
Hedge uses derivatives that comprise options, futures, and swaps as a measure for hedging on a potential loss from any kind of investment.
For example, if a particular stock one invests in drops one’s thoughts; one buys put options with regard to being safe from losing as much.
Asset Allocation:
Efficient resource distribution means distributing investments across various asset categories (including stocks, bonds, or real estate) as per the risk tolerance and financial goals of the investor.
It seeks to strike a balance in pay-offs desired with the risks which someone wants to be exposed to.
5. How to avoid market risk?
Market risk cannot be completely avoided; however, a certain level can be managed that will reduce its burden through diversification, hedging, and proper allocation of assets.
For example, most market fluctuations have been protected an investor by merely diversifying across asset classes, sectors, or geographies.
This way with financial instruments like options and futures, added to a good asset allocation in line with risk profiles, the management of such risks is highly made possible.