Expert Level

Learn advanced topics about trading strategies, risk management and more.

Lesson 10: Market Risk

What is Market Risk?

Market
risk is the potential for an investor to suffer losses due to factors that
affect the overall performance of the financial markets in which he or she is
involved. Market risk, sometimes referred to as “systematic risk,” cannot
be removed by diversification, although it can be hedged against in certain
ways. Market risk factors include recessions, political turmoil, interest rate
changes, natural disasters, and terrorist attacks. Systematic and systemic risk
tends to affect the whole market at the same time.

This can
be contrasted with a non-systematic threat that is peculiar to a particular company
or industry. Also known as “non-systematic risk,” “relevant risk,” “diversifiable
risk,” or “residual risk,” in the sense of an investment portfolio,
non-systematic risk can be minimized by diversification.

Understanding Market Risk

Market
(systematic) risk and general (unsystematic) risk are two main types of
investment risk. The most common types of market risk include interest rate
risk, equity risk, currency risk, and commodity risk.

Publicly
traded firms in the United States are required by the Securities and Exchange
Commission (SEC) to report that their profitability and results can be related
to the performance of financial markets. This guideline is meant to detail the
vulnerability of a company to financial risk. For example, a company offering
derivative securities or foreign exchange futures may be more vulnerable to
financial risk than companies that do not provide such forms of investment.
This information helps investors and traders to take decisions on the basis of
their own risk management rules.

In contrast
to market risk, real risk, or “unsystematic risk,” is directly linked to the
quality of a particular protection and can be guarded against portfolio
diversification. An example of a non-systematic threat is a corporation that
declares bankruptcy, making its shares worthless to investors.

Main Types of Market Risk

Interest rate
risk shall cover the uncertainty that may follow interest rate fluctuations due
to fundamental factors, such as central bank announcements related to changes
in monetary policy. This risk is most applicable to investment in fixed-income
assets, such as bonds.

Equity
risk is the threat involved in changing stock investment values, and commodity
risk includes rising commodity prices, such as crude oil and maize.

Currency
risk or exchange rate risk results from a change in the value of one currency
in comparison to another; creditors or companies holding capital in another
country are subject to currency risk.

Volatility and
Hedging Market Risk

The market
risk occurs due to changes in prices. Standard fluctuations in the prices of
stocks, currencies and commodities are referred to as price volatility.
Volatility is measured in annualized terms and may be expressed as an absolute
number, such as $10, or as a percentage of the initial value, such as 10%.

Investors
can use hedge strategies to defend against uncertainty and market risk.
Targeting specific stocks, investors can buy put options to cover against a
downside move, or investors who want to hedge a large portfolio of shares can
use index options.

Measuring Market Risk

Investors
and analysts use the value-at-risk (VaR) approach to measure market risk. VaR
modeling is a statistical risk management approach that quantifies the
potential loss of the stock or portfolio as well as the probability of the
potential loss happening. Although well-known and commonly used, the VaR method
requires certain assumptions that restrict its accuracy. For example, it
assumes that the composition and quality of the portfolio being evaluated will
remain unchanged over the specified period. Although this may be suitable for
short-term horizons, it may provide less accurate measurements for long-term
investment.

Beta is another important
risk factor as it calculates the uncertainty or market risk of a commodity or
portfolio relative to the market as a whole; it is used in the capital asset
pricing model (CAPM) to determine the expected return of the asset.