Market Risk

Market risk is the risk that the value of an investment may vary or decrease owing to changes in unpredictable market circumstances.

It includes changes in 

• Currency exchange rates
• Interest rates 
• Stock prices
• Rate of inflation 
• Commodity prices affect a company's assets.

Major financial institutions, for instance, hold a variety of financial instruments, including derivatives, stock goods, etc. The worth of these holdings will fluctuate daily depending on changes in various MR variables, including interest rates and foreign currency rates.

One of those risk variables might suddenly and unexpectedly change, leading to far larger losses than anticipated. Therefore, firms must efficiently monitor and manage this risk, also known as market risk, to themselves from negative consequences.

These market conditions might include 

• Crisis or Depressive Disorders 
• Changes in government policies impacting important interest rates 
• Natural catastrophes
• Political upheaval
• Terrorism, etc.

Market Risk is also known as "Systematic risk," as it impacts the whole financial market. As a result, no one or organization has authority over these. However, various measures can be used to control or limit such risk.

The strategies may recommend diversification of investments. Furthermore, diversity should occur across asset classes and portfolios unconnected to the market. The portfolio's or financial assets' lack of association with the stock market will bring stability. 

MR and specific/unsystematic risk are two main categories that can be used to classify the overall investment risk. Unlike specialized risk, MR depends on the success of the whole market rather than any one firm, industry, or sector.

An investor must thus be aware of the macroeconomic forces influencing the financial market. 

There are also different types of risk associated with market risk. The systematic risk depends on the outcome of the entire market and is not explicitly linked to the business or sector in which an investor has invested.

The status of the balance of payments, inflation, fiscal deficits, geopolitical concerns, and other macroeconomic variables relevant to the financial market must all be monitored by investors as a result.

How Can Market Risk Be Hedged?

Holding two or more opposite positions at once is known as hedging, and the goal is to offset any unforeseen losses from a particular position with certain benefits from another. As was previously discussed, hedging MR is but one method of controlling trading risk.

Investors use diverse hedging techniques to protect themselves from unanticipated market volatility. By possibly balancing losses during market downturns, futures hedging may help minimize risk in a portfolio.

Futures are a great tool for hedging because of their leverage, allowing you to manage a huge asset with a small investment.

Certain investors prefer options trading because it enables them to utilize delta hedging and risk reversal to protect their positions. 

Holding two or more investments simultaneously to balance the losses from one with gains from another is called hedging. For example, one strategy for controlling your trading risk is to hedge market risk. 

Many traders understand that some risks are essential to achieve the long-term profits they seek, but hedging provides some risk mitigation while still allowing them the exposure they desire.

Other investors use future contracts to partially eliminate the uncertainty around the future price of the underlying security and hedge their holdings in commodities, stocks, bonds, etc.

How Should Market Risk Be Calculated?

An investment's Market Risk Premium (MRP) can be determined using Value-at-Risk (VaR) or VaR. VaR denotes the greatest amount (with a specified probability) that the investment might lose in a given amount of time, given the current state of the market

 It is denoted mathematically by the following:

\(Portfolio Value x Z-score within the given Confidence Interval\)

On the other hand, the MRP offers a numerical representation of the increased return that market players want due to the more risk they are willing to assume. It is denoted mathematically by the following:

\(Expected Return - The Risk-Free Rate Of Return = Market Risk Premium\)

Several restrictions apply to the VAR technique as well. The approach includes calculating each asset's risk, return, and correlation. Therefore, calculating VAR becomes exceedingly difficult if a portfolio has many varied assets. 

It also assumes that the holdings will remain the same for a specific period. Consequently, because the investment portfolio's contents are continually changing, it is more useful for investments that are short-term and inaccurate for long-term ones.
Value-at-risk (VaR) and beta are the basic metrics to assess market risk.

1. Value-at-risk (VaR) 

Value-at-risk is a statistical technique that, when used over a predetermined time, may quantify the risk's magnitude (possible loss) and its propensity to occur(occurrence ratio). 

2. Beta

Based on its historical performance, beta compares a stock's volatility to that of the stock market as a whole.

In other words, it affects whether equities move in the same way as the market. While some of these tactics might be pretty simple, and others can be very sophisticated, neither of these approaches has a generally acknowledged mechanism for estimating market risk.

Types of Risks

Interest rate risk, foreign currency risk, commodity prices risk, and equity price risk are the four main categories of MR.

1. Risk of interest

This kind of risk manifests itself when the value of a security decline as a result of shifts in the current and longer-term interest rates. 

Further categories of interest rate risk are:

• Options risk, 
• Repricing risk, 
• Basis risk
• Yield curve risk

Changes in an economy's interest rate have a greater impact on fixed-income products like bonds. This is because a country's central bank can change the interest rates now being applied in the economy by changing its monetary policy. 

Such fluctuations in interest rates directly impact the prices of investments and securities. Therefore, the demand for instruments with lower interest rates will decrease when the market interest rate is high. 

Similarly, investments will transfer to financial instruments with greater interest rates if the market interest rate falls. Conversely, market volatility will likely increase if interest rates suddenly rise or decrease.

Interest rate changes affect asset prices as, depending upon how they are carried out, they may influence the country's pace of consumption and investment to grow or decrease. 

Consumers frequently spend less and save a little more when interest rates increase compared to when they decrease. Any marketplace, including shares, commodities, and bonds, is subject to interest rate risk.

The market value of different bonds and financial instruments is affected by changes in interest rates. The value of the current securities will decrease if interest rates rise and vice versa.

2. Risk of Currency Conversion

Variations in the exchange values between the US dollar and other currencies give rise to this type of risk. Likewise, changes in exchange rates between different currencies cause currency risk.

Exchange rates are not country-specific and are instead based on the exchange of currency prices worldwide. As a result, currency risk is more likely to affect investors investing in global markets and foreign nations. 

Currency fluctuations will impact businesses that conduct international trade in addition to them since these businesses' net inflows and outflows will alter when currency rates change.

3. Risk of Commodity Price

The price variations of commodities like gold, silver, oil, etc., give rise to this risk. The risk associated with commodity prices impacts not just international corporations but also common individuals.

Commodity risk develops due to shifts in the price of necessities on international markets, such as crude oil, which impact global financial markets. 

Such risk is uncontrollable for any nation and may arise from variations in supply and demand, the political environment, governmental rules, restrictions, etc. The danger of price swings for other important commodities, such as bullion, steel, copper, natural gas, etc., may be comparable.

4. Risk of Equity Price

Stock price swings are referred to as this form of risk. In addition, the total MR contains a significant amount of equity price risk. Equity risk is the danger of potential fluctuations in stock prices and stock indexes. 

Numerous factors may be to blame for this. These are 

• Major discoveries or innovations 
• Launch of new goods
• Changes to laws and regulations 
• Shifts in the general economic environment
• Big epidemics, etc. 

The volatility of stock prices can be greater than that of certain other asset groups. This is because a security's price can fluctuate drastically quickly, frequently resulting in a decline in value. Equity price risk is the term for this. 

There are just two categories of equity risk, 

• Systematic Risk
• Unsystematic Risk

Even though there are numerous factors that influence share prices. Unsystematic risk relates to a specific firm, whereas the first type of risk is an industry-wide risk.

5. Risk of Marginality

Unfavorable margin calls covering a position cause margin risk. An investor may have unpredictable cash flows as a result of this.

Risk Indicators for the Market

Some of the early warning signs of an MR crisis are the ones listed below:

• The implied market volatility is high
• Spreads between high-yield and Treasury bonds are increasing
• Flattening of the yield curve for Treasury bonds
• A big worldwide currency weakening

How to do the Assessment of Market Risk? VaR and Beta are the two main techniques for quantifying market risk for the assessment.

1. VaR

VaR is a statistical technique used over a predetermined period to calculate the greatest possible loss of the portfolio's value and the likelihood of such a loss.

Value at risk is a metric used to evaluate the long-term financial risk to an organization, investment portfolio, or open position. 

VaR calculates the likelihood that a loss will occur as well as the potential for loss. Based on its historical performance relative to the market as a whole, a stock's beta reveals how volatile it is.

The advantages are:

• The idea of MR makes it much easier to comprehend how volatile financial goods may be.
• Investors may use it to calculate the actual return on investment as well.

On the other hand, the disadvantages are:

• It cannot be completely minimized; at best, it may be hedged. Additionally, hedging entails a substantial expense and a unique set of dangers.
• In times of recession or cyclical swings in the economy, managing MR is especially difficult.
• VaR only indicates the likelihood of a loss; it does not show an investor the maximum probable loss. 

2. Coefficient Beta

The beta coefficient is a metric for comparing an investment or portfolio's fluctuation to the market. For example, the beta coefficient measures a security's or investment portfolio's sensitivity or connection to changes in the general market. 

It provides information on asset return in light of systematic risk and is useful in the Capital Asset Pricing Model (CAPM). Adding a stock or asset to a diverse portfolio aids in determining the risk increase.

By evaluating the returns of a single asset or portfolio to the return of the whole market, we may determine a statistical indicator of risk and determine the percentage of risk that can be assigned to the market.

A systematic risk to the market can likewise be considered to exist concerning this asset.

A beta number larger than "1" denotes increased market volatility for the investment or securities. It can rise more quickly than the market in an upturning economy and vice versa. 

Estimating the cost of capital (Re) in valuation models is one of the most often-used applications of beta. 

The market's overall risk serves as the sole basis on which the CAPM estimates an asset's beta. The cost of equity calculated by the CAPM reflects that most clients have diversified portfolios in which inefficient risk has been successfully mitigated.

The investment is, therefore, quite risky, but it also has the potential for substantially larger returns than the market. Similarly, a less volatile investment than the market has a beta coefficient below one. 

As a result, the investment is a safe, low-risk choice, but the potential returns are also constrained.

Laws Governing Market Risk

Regarding the disclosure of the MR of investments, there are some rules as well. Companies are required by the Securities and Exchange Commission to include a section in all annual reports made on Form 10-K that details their exposure to MR.

Companies must explain their involvement in financial markets and how market volatility may affect them. For example, many businesses appear to operate simply to the public, yet they may be engaged in investing and trading in sophisticated financial instruments and derivatives. 

Through such unsafe investment practices, they can endanger the funds of trusting investors. An investor can therefore assess the risk of buying into such a firm using the mandatory data in its Annual Report.

The market's risk rule (MRR) establishes capital needs and risk management guidelines for banking organizations that engage in significant trading. Worldwide banks that reach specified asset or trading criteria are subject to the rule. 

The rule is based on market risks associated with the trading positions, including interest rate, foreign currency, stock, and commodities risks. 

Along with stress testing, the law mandates independent marketplace risk management for banks. In addition, the regulation has been revised to reflect changes in national risk categories and securitization positions.

Conclusion

Market Risk impacts the entire market and cannot be removed by diversification. However, the best course of action is for investors to assess MR using the available tools before hedging against it.

MR is the chance of losing money due to shifting interest rates, geopolitical instability, or recessions that affect how well the financial markets function.

Since it cannot be completely reduced by diversification, it is often referred to as systemic risk. Contrarily, the specific risk is exclusive to a given stock or business area and may be reduced by diversification.

Inflation can increase the risk by influencing corporate performance, consumer behavior, and investor confidence. As a result, higher interest rates may be employed by monetary policy to combat inflation, although doing so might trigger a recession and slow down the market as a whole.

This is distinct from inflationary risk, which is the chance that your investment might underperform the rate of return due to rising costs brought on by inflation. Since inflationary risk does not affect the general performance of the financial markets, it is not a particular kind of risk of market 

It is a form of investment risk, though. The inflationary risk may be reduced by diversification, early investment to benefit from compound interest, and aggressive investing when you are younger. 

You may discover WSO's Financial statement modeling course here if you still need materials to help with your knowledge of Market risk.

Researched & Authored by Naveeth Rishwan Habeeb | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

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