Market Risk: Definition, Overview & Application
Investments are an inherently risky venture.
The market commonly sees unanticipated fluctuations and price volatility. This can affect the entire financial market. This means that people can both gain and lose large amounts of capital when investing in the market.
This is where the market risk comes into play. But what exactly is market risk and what are its primary sources?
Let’s take a closer look.
Here’s What We’ll Cover:
What Is Market Risk?
Market risk can be defined as the risk of loss due to the many factors that affect an entire market or asset class.
Market risk is also known as systematic risk or undiversifiable risk. This is because it affects all asset classes and is unpredictable. It is also because an investor can only mitigate this form of risk by diversifying and hedging a portfolio.
This risk is not something that is specifically associated with a certain company or industry that you may be invested in. Instead it is dependent on the performance of the whole market.
This makes it far more difficult to predict. It makes it necessary for an investor to keep a keen eye on a number of different variables associated with the financial market.
This may be factors such as inflation, interest rates, fiscal deficits and geopolitical factors amongst others.
What Are the Different Types of Market Risk?
There are four commonly accepted types of market risk. These are;
1. Interest Rate Risk
Interest rate risk comes from unanticipated fluctuations in the interest rates. This could be due to many things, including monetary policy measures undertaken by banks.
The yields that come from securities across all of the markets must be equalised in the long run. This is by adjustment of market demand and supply.
There are different types of risk exposures that can come up when there is a change of interest rates. These may be basis risk, options risk, term structure risk and repricing risk.
2. Equity Price Risk
Equity price risk is a form of risk that comes from security price volatility. Security price volatility is the risk of a decline in the value of a security or a portfolio.
Equity price risk can be either systematic or unsystematic risk. An unsystematic risk can be reduced through diversifying your portfolio, whereas systemic risk can’t be mitigated at all.
For example, in a global economic crisis, equity price risk is systematic because it affects a wide range of asset classes.
3. Foreign Exchange Risk
Foreign exchange risk, or currency risk as it’s otherwise known, arises when currency exchange rates are volatile. A global firm may be exposed to currency risk due to imperfect hedges when conducting business.
For example, if a UK business person has released a 50% return on investment in China, but hasn’t factored in the exchange rate between GBP and the Chinese Yuan, then the investor will have a reduced return.
This type of risk can be mitigated by hedging with currency exchange-traded funds.
4. Commodity Risk
A commodity price risk is a volatility in market price due to the price fluctuation of a commodity. A commodity’s price can be affected by a number of factors. These include politics, seasonal changes, technology and the current market conditions.
For example, say there is an oversupply of crude oil. This would mean that oil prices would fall over time. So a company that has heavily invested in oil drilling will face a commodity price risk.
Their profit margin would fall as the price of oil falls since it still has to operate at the same cost but their income would be diminished.
There are a number of risks when trading or investing in the market. Whilst many of these risks can be mitigated, a percentage cannot.
That is why any investment into the market should be thoroughly researched and maintained carefully.
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