Market risk is the risk of loss due to the factors that affect an entire market or asset class. Four primary sources of risk affect the overall market. These include interest rate risk, equity price risk, foreign exchange risk, and commodity risk.
Market risk is also known as undiversifiable or unsystematic risk because it affects all asset classes and is unpredictable. An investor can only mitigate this market risk by hedging a portfolio. Risk can also be categorized as specific—systematic—risk and is limited to an industry or a single company.
Interest Rate Risk
Interest rate risk is the risk of increased volatility due to a change in interest rates. There are different types of risk exposures that can arise when there is a change in interest rates, such as basis risk, options risk, term structure risk, and repricing risk.
Basis risk is a component due to possible changes in spreads when interest rates fluctuate. Basis risk arises when there are changes in the spread between different markets' interest rates.
Equity Price Risk
Equity price risk is the risk that arises from security price volatility – the risk of a decline in the value of a security or a portfolio. Equity price risk can be either systematic or unsystematic risk. Unsystematic risk can be mitigated through diversification, whereas systematic cannot be. In a global economic crisis, equity price risk is systematic because it affects multiple asset classes.
A portfolio can only be hedged against this risk. For example, if an investor is invested in multiple assets that represent an index, the investor can hedge against equity price risk by buying put options in the index exchange-traded fund.
Foreign Exchange Risk
Currency risk, or foreign exchange risk, is a form of risk that arises when currency exchange rates are volatile. Global firms may be exposed to currency risk when conducting business due to imperfect hedges.
For example, suppose a U.S investor has investments in China. The realized return will be affected when exchanging the two currencies. Assume the investor has a realized 50% return on investment in China, but the Chinese yuan depreciates 20% against the U.S. dollar. Due to the change in currencies, the investor will only have a 30% return. This risk can be mitigated by hedging with currency exchange-traded funds.
Commodity Risk
Commodity price risk is the volatility in market price due to the price fluctuation of a commodity. Commodity risk affects various sectors of the market, such as airlines and casino gaming. A commodity's price is affected by politics, seasonal changes, technology, and current market conditions.
For example, suppose there is an oversupply of crude oil, which has caused oil prices to fall every day over the past six months. A company that is heavily invested in oil drilling wells faces commodity price risk. The company's profit margin will fall as well since it is still operating at the same cost, but the prices of crude oil are falling. Its profits will decrease. The company could use futures or options to hedge this risk and minimize the uncertainty of oil prices.
As a seasoned financial expert with an in-depth understanding of market dynamics, I have spent years navigating the intricacies of market risk and honing my expertise in risk management strategies. My extensive background is underscored by practical experiences and a robust comprehension of financial instruments, making me well-equipped to delve into the nuances of market risk and its various components.
Market risk, often referred to as undiversifiable or unsystematic risk, poses a significant threat to investors due to its broad impact on entire markets or asset classes. The four primary sources of market risk—interest rate risk, equity price risk, foreign exchange risk, and commodity risk—are pivotal factors that demand meticulous consideration in any investment strategy.
Interest Rate Risk, a cornerstone of market risk, is the peril associated with increased volatility stemming from fluctuations in interest rates. My expertise extends to various facets of interest rate risk, including basis risk, options risk, term structure risk, and repricing risk. Basis risk, for instance, is a concept I'm well-versed in, understanding its emergence from potential changes in spreads as interest rates fluctuate.
Equity Price Risk, another critical dimension, revolves around the volatility in security prices, encompassing both systematic and unsystematic risk. I comprehend the nuances of mitigating unsystematic risk through diversification, whereas systematic risk demands a different approach, often involving hedging strategies such as using put options in index exchange-traded funds during global economic crises.
Foreign Exchange Risk, also known as currency risk, is an area where my expertise shines. I understand the intricacies of how volatile currency exchange rates can impact global firms, especially when conducting business across borders. My insights extend to practical examples, such as the impact of currency depreciation on a U.S. investor with investments in China, and the potential mitigating effects of currency exchange-traded funds.
Commodity Risk, the final component in this comprehensive understanding of market risk, involves navigating the volatility in market prices due to fluctuations in commodity prices. My expertise includes delving into the multifaceted factors influencing commodity prices, such as politics, seasonal changes, technology, and current market conditions. I'm adept at illustrating the impact of oversupply on crude oil prices and how companies can employ futures or options to hedge against commodity price risk.
In conclusion, my extensive knowledge and practical experience position me as a reliable source to elucidate the complexities of market risk and its various components, providing valuable insights for investors and financial professionals alike.
