Market risk, also known as systematic risk, refers to the prospects that a company, individual or entity may lose capital due to obstructions in the financial markets. This affects the performance of the company and poses a great challenge in meeting their financial goals.
In simple terms, market risk denotes the risk of market price that arises due to uncontrolled fluctuations and the movement of interest rates. Besides, market risk makes up a major category of investment risk along with specific risk. We shall understand all these aspects better.
Market Risk: Key Takeaways
- Market risks arise due to fluctuations in financial markets. Recessions, changes in interest rates, changes in exchange rates and geopolitical events pose a market risk.
- Unlike unsystematic or specific risks, it is not possible to eliminate market risk or systematic risk by diversification.
- Market risk affects the entire financial market which makes it harder to manage.
- It refers to the probability of financial loss on an investment.
Market Risk: Meaning and Definition
Market risk is a quintessential financial risk that arises due to aspects that affect the financial markets. These include interest rates and exchange rate changes, geopolitical events, recession, etc.
There are two important categories of investment risks. These are Market Risk (Systematic Risk) and Specific Risk (Unsystematic Risk). Where specific risk affects only a particular aspect of the financial market or the entity, market risk affects the entire financial market. It is much easier to measure and manage specific risks in comparison to market risk.
A movement in market variables like price and volatility in the market poses market risk. A change in prices of commodities, stocks and currencies also causes market risk.
What is Market Risk for Banks?
The activity of a bank in the capital markets poses a market risk for it. The causes for such a financial risk include the uncertainties of interest rates, credit spreads, equity markets, and commodity prices.
Commodity prices have a role to play since many times, banks are involved with companies that produce and sell commodities. A change in the value of the commodity changes the value of the company. This in turn affects the value of investment made. A change in commodity prices is hard to predict though as they are caused by demand and supply shifts.
Banks are more exposed towards market risk if they are investors in sales, trading or capital markets. They use hedging their investments with others as a way to manage market risk.
Market Risk vs. Credit Risk
To understand market risk better, we shall go through the common differences between market risk and credit risk. They are as follows:
| Market Risk | Credit Risk |
| Market risk is the probability of financial loss due to fluctuations in market prices, volatility, etc. | Credit risk is the probability of financial loss arising because of a default on credit by a borrower. |
| A prime example of market risk is a broad decline in stock prices held by a company. | An example of credit risk includes a supplier going bankrupt who was lent money by a company. |
| Market risk is a systematic risk and cannot be managed solely by diversification. | Credit risk is an unsystematic risk and can be managed well by diversification of portfolios. |
Market Risk and Its Prominent Types
Market risk is a broad aspect of financial risk. Some most prominent market risks in the finance industry are discussed as follows:
- Interest Rate Risk: It is the risk arising from fluctuations in interest rates that affects investments. For instance, bond value falls when interest rate rises.
- Inflation Risk: Monetary inflation impacts consumer behavior, business performance and investor confidence in the market.
- Currency Risk: The risk arising from the movement of foreign exchange rates. Import/export companies and MNCs (Multinational Corporations) are most vulnerable to currency risk.
- Equity Risk: It refers to the risk of stock prices declining because of market volatility which in turn affects equity investment entities.
- Commodity Risk: It is the risk of changes in commodity prices. If prices rise immensely, companies relying on commodities may suffer losses.
- Volatility Risk: It refers to the risk of a serious change in prices because of changes in market volatility.
- Systemic Risk: It is the risk of the entire financial market collapsing.
How to assess Market Risk?
Now that we have learned about market risk, its meaning and prominent types, it is important to look into ways to assess and manage them.
Investors and bankers generally use the Value-At-Risk (VaR) method to measure or assess market risk. However, this method is not suitable for long-term investments. Thus, the Risk Premium method and Beta are also used to assess market risk.
VaR Method (Value-At-Risk)
VaR is a statistical financial risk management method. It analyzes the prospective loss of a stock or portfolio along with the probability of that loss occurring. It measures the maximum probable loss of a portfolio at a certain confidence level over a period of time.
For instance, a 90% of VaR suggests that there is a 90% probability of a portfolio not losing more than the expected loss.
Equity Risk Premium (ERP)
Equity risk premium or ERP refers to a vital market risk measure. It denotes the excess returns demanded by an investor to invest in a particular stock above the risk-free return rate.
It is equal to the difference between the risk-free return rate and the expected return from the financial stock market.
Beta
Beta is an important risk metric used to measure market risk of a portfolio or security against the overall market. It assesses the relative volatility and is utilized in CAPM (Capital Asset Pricing Model) for the calculation of expected returns on an asset.
A beta greater than one refers to more volatility of the asset in comparison to the market. The calculation of the average beta of its assets is a way to assess market risk associated with a portfolio.
Strategic Ways to Deal With Market or Systematic Risk
Though it is not completely possible to avoid market risk as an investor, there are various strategies of hedging that can be used to guard against market volatility and reduce the impact of market risk as much as possible.
One can use these five-step market risk management strategies to guard their portfolio. These steps are as follows:
1. Studying Currency Profiles
When making an investment in a foreign market, it is important to analyze the currency profiles of the companies one is planning to invest in.
It is advisable to allocate one’s assets along a variety of industries to manage market risk while investing in such companies or markets that have the backing of a strong currency.
2. Watching Interest Rates
Shifting investments to account for interest rate changes is a measure to mitigate market risk. Besides, one should focus on monetary policy. For instance, if interest rates on bonds are increasing, you may shift your investments to shorter term bonds.
3. Maintaining Liquidity
Market volatility poses a serious problem of operations and gives birth to liquidity risk and operational risk. It is when it becomes hard to buy or sell assets in the market and thus lack enough cash to run the operations of the company.
Thus, a company should always maintain enough liquidity to keep the company operations running while it mitigates market risk.
4. Investing in Staples
Even when the entire economy is poor, there are some companies that seem to be doing well. These are those companies that produce consumer staples. This is simply because no matter how the economy is doing, there are some things that are necessary to people like lights, food, toothpaste, toilet paper, etc.
By making some investment in staples, a company can still make profits while the market is crashing, there is high unemployment or recession.
5. Thinking Long Term
No matter how much one tries, it is not possible to fully eradicate market risk and volatility. However, a long-term investment strategy helps in escaping most of the market volatility effects.
A company can make small changes according to market trends or fluctuations but it is not advisable to entirely upend its’ strategy.
Instead, think of a long-term investing strategy from the beginning since it is easier for long-term investors to bounce back from the impact of market risk in comparison to short-term investors who are more affected by market volatility.
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Market Risk FAQs
Q1. What is the difference between specific risk and market risk?
Ans: Market risk and specific risk are the two categories of investment risks. Market risk affects the whole market at a time whereas specific risk is particular to an industry or company.
While market risk is systematic in nature, specific risk is unsystematic. Further, portfolio diversification cannot be used to manage market risk whereas it is a good way to mitigate specific risk.
Q2. What are the various types of market risks?
Ans: The varied types of market risks include equity risk, commodity risk, interest risk, currency or exchange rate risk, inflation risk, volatility risk and systemic risk.
Q3. Is inflation a financial market risk?
Ans: Yes. Inflation is a market risk as it impacts consumer behavior, business performance and investor confidence in the market. Inflation risk is a type of market risk studied in financial studies.
