What is Market Risk?
Market risk is the risk that an investor faces due to the decrease in the market value of a financial product arising out of the factors that affect the whole market and is not limited to a particular financial commodity. Often called a systematic risk, market risk arises because of uncertainties in the economy, political environment, natural or man-made disasters or recession and can only be hedged, however, cannot eliminate by diversification.
Types of Market Risk
There are four major types of market risk.
#1 – Interest Rate Risk
Interest rate risk arises when the value of security might fall because of the increase and a decrease in the prevailing and long-term interest rates. It is a broader term and comprises multiple components like basis risk, yield curve risk, options risk, and repricing risk.
#2 – Foreign Exchange Risk
Foreign exchange risk arises because of the fluctuations in the exchange rates between the domestic currency and the foreign currency. The most affected by this risk is the MNCs that operate across geographies and have their payments coming in different currencies.
#3 – Commodity Price Risk
Like foreign exchange risk, commodity price risk arises because of fluctuations in the prices of commodities like crude, gold, silver, etc. However, unlike foreign exchange risk, commodity risks not only affect the multinational companies but also the common people like farmers, small business enterprises, commercial traders, exporters, and governments.
#4 – Equity Price Risk
The last component of market risk is the equity price risk which refers to the change in the stock prices in the financial products. As equity is most sensitive to any change in the economy, equity price risk is one of the biggest parts of the market risk.
Market Risk Premium Formula
One factor used to calculate gauge market risk is the calculation of market risk premium. Simply put market risk premium is the difference between the expected rate of return and the prevailing risk-free rate of return.
Mathematically market risk premium formula is as follows:
The market risk premium has two major aspects–required marked risk premium and historical premium. It is based on the expectations that the investor community has in the future or based on historical patterns.
The risk-free rate is defined as the expected return without taking any risk. Most often US treasury rate as US sovereign risk is almost zero is referred to as risk-free rate.
Example of Market Risk
Let’s take an example.
Let’s consider the example of an IT major firm–HP. An investor wants to calculate the market risk premium associated with the stock price which is currently quoting at $1000. Let’s assume the investor expects the stock price to hot $1100 because of expected growth. The following is the calculation in Excel.
Calculation of Risk Premium will be –
Market Risk Premium = 11%
Some advantages are as follows.
- Most often than not, financial products are sold to the investor community by aggressive marketing and by presenting only the growth part while completely ignoring the risks and downfalls. This is the reason we see such products being bought more in the economic expansion cycles while in the recession, investors especially the retail ones are trapped. Had the investor known of the concept of market risk and its calculations, they can understand the financial products in a much better way and decide if it suits them for such volatilities.
- Market risk premium, as explained in the example above, helps an investor to calculate the real rate of return. Even though the financial product might enjoy presenting a lucrative return, the investor should gauge the investment in terms of the real rate it provides. This can be calculated by taking into account the prevailing risk-free interest rate and inflation rate.
Some disadvantages are as follows.
- We cannot completely ignore them. It can only be hedged which comes with cost and intensive calculations. An investor has to be apt to understand what data to analyze and what data it should filter out.
- It is very prone to recession or cyclic changes in the economy. Ans since it affects the whole market simultaneously, it is even more difficult to manage as diversification will not help. Unlike credit risk, which is very much counterparty specific, market risk affects all asset classes.
- It is an important part of risk management. As it affects the whole market simultaneously, it can be lethal for an investor to ignore market risk while building a portfolio.
- They help in measuring the maximum potential loss for a portfolio. There are two major components here–time frame and the confidence level. The time frame is the duration for which the market risk premium has to be calculated while it bases the confidence level on the investor’s comfort level. We express it in % terms like 95% or 99%. Simply put confidence level determines how much of a risk an investor or portfolio manager can take.
- It is a statistical concept and hence its calculations are very heavy in numbers. The various tools/mechanisms used for calculation are – Value at risk expected shortfall, variance-covariance, historical simulation, and monte Carlo simulation.
- Since market risk impacts the whole investor community irrespective of their credibility or the asset class they operate on, it is closely watched by regulators across the world. In fact, in the last 25 years, we have witnessed about 4 major regulations and many more minor enhancements. Basel Committee is the main regulatory body that comes up with these rules or advisories. The member nations are free to adapt or add more scrutiny to these regulations to make their banking systems much more robust.
It is an integral part of any portfolio. It arises because of the additional return that an investor expects to generate from an investment. If hedged, it can lead to better results and safeguard your losses when the market experiences downward cycles.
This has been a guide to what is market risk, and its definition. Here we discuss the top 4 types of market risk including interest rate, forex, commodities and equity along examples, advantages and disadvantages. You can learn more about financing from the following articles –