What Is Market Risk? - Tavaga (2024)

Key Takeaways

Market risk is losses in investment faced by the investor due to fluctuations in the market, like economic slowdown or natural disaster, etc.
Market risk affects the overall performance and productivity of the economy.
The difference between the expected rate of return and the risk-free rate is known as the market risk premium.
Market risks are commodity risk, currency risk, equity risk, and interest rate risk.

Market risk is the risk of the investor losing his money because of the market- or economy-related factors, like political uncertainty, the global slowdown, interest rate change.

Market risk is also known as systematic risk. These are the risks that affect the entire economy and macroeconomic conditions. It is the opposite of unsystematic risk, which is a company-specific risk.

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The best way to handle market risk in a portfolio is to hedge against the risk drivers.

For example, a portfolio heavily invested in airline stocks has oil cost as its primary risk driver. Hedging against oil price rise would offset market risk.

Market Risk meaning

Market risk is losses in investment faced by the investor due to fluctuations in the market, which affects the overall productivity and performance of the economy. Many factors such as economic slowdown, recession, changes in interest rate, natural calamities, political turmoil, etc. cause fluctuations in the market.

Types of market risk

Interest Rate Risk – this risk emerges when changes in the interest rates affect the return on investments.

Commodity Risk – A risk that occurs when prices of a particular commodity change (example wheat, crude oil), which affects the return on investments.

Currency Risk – This risk emerges when the foreign exchange rate changes. Most of the MNCs are prone to this type of risk.

Market Risk Premium

The excess return earned on the investment because of the additional risk-free rate is known as the market risk premium. For example, a person is investing in government bonds at a 4% rate, and if the rate of return on the stock investment is 14%, then the market risk premium is 10%.

In the investment realm, the higher the risk, the higher the return. If an investor or a person invests in government bonds, he will get a marginal return, where the rate of risk is low. If he invests in the stock market, he will get a higher return, but the stock market bears a higher risk. This is the market risk premium. The difference between the expected rate of return and the risk-free rate is known as the market risk premium. The risk-free rate is the rate return on investment, on which the impact of market risk is minimal.

Market risk measurement

Investors or analysts use a value at risk method to measure the arising risk. VaR estimates the investor’s portfolio loss or probable potential loss. Value at risk defines three components: confidence level, time period, and a loss percentage or amount.

How to mitigate market risk?

Risk management is the identification of sources of risks, assessment of the risk, and controlling the exposure by developing the strategies to reduce the impact of the risk on the growth of the business. Worldwide most of the banking institutions adopt the Basel Accords for identification, assessment, and controlling exposure to credit, market, and operational risk.

Market Risk Overview:

Definition: Market risk refers to the potential losses in investment faced by investors due to fluctuations in the market. These fluctuations can be triggered by factors such as economic slowdown, recession, changes in interest rates, natural calamities, political turmoil, and more. The impact of market risk extends beyond individual investments, affecting the overall productivity and performance of the economy.

Market Risk Premium: The market risk premium is the difference between the expected rate of return and the risk-free rate. It represents the excess return earned on an investment due to the additional risk taken. For instance, if a government bond yields a 4% return and a stock investment yields a 14% return, the market risk premium is 10%.

Types of Market Risk:

Interest Rate Risk:
- Emerges when changes in interest rates affect the return on investments.
Commodity Risk:
- Occurs when prices of specific commodities (e.g., wheat, crude oil) change, impacting investment returns.
Currency Risk:
- Arises when foreign exchange rates change, particularly affecting multinational corporations.
Equity Risk:
- Relates to changes in index or stock prices, impacting equity investments.

Systematic vs. Unsystematic Risk:

Market risk, also known as systematic risk, affects the entire economy and macroeconomic conditions. It is distinct from unsystematic risk, which is company-specific.

Causes of Market Risk:

Factors include:

Global pandemics
Global recession
Economic slowdown
Natural disasters
Changes in monetary policy
Political turmoil

Market Risk Measurement:

Value at Risk (VaR):

Investors and analysts use VaR to estimate the potential loss in a portfolio within a given time period at a specified confidence level. VaR considers three components: confidence level, time period, and a loss percentage or amount.

Mitigating Market Risk:

Risk Management:

Involves the identification, assessment, and control of sources of risk.
Strategies are developed to reduce the impact of risk on business growth.

Basel Accords:

Widely adopted by banking institutions globally for the identification, assessment, and control of exposure to credit, market, and operational risk.

Hedging:

A strategy to offset risk drivers in a portfolio. For example, hedging against oil price rise for a portfolio heavily invested in airline stocks.

In conclusion, effective risk management involves a comprehensive understanding of market risk drivers, strategic planning, and the implementation of measures such as hedging to minimize exposure and optimize returns in dynamic market environments.