What is Market Risk?

Types of Market Risk

There are four significant types of market risk.

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#1 – Interest Rate Risk

Interest rate riskInterest Rate RiskThe risk of an asset’s value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable. read more arises when the value of security might fall because of the increase and 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 domestic and foreign currencies. The most affected by this risk is the MNCs operating across geographies and paying in different currencies.

#3 – Commodity Price Risk

Like foreign exchange riskForeign Exchange RiskForeign exchange risk is an unfavourable change in the settlement value of a transaction entered in a currency other than the base currency (domestic currency), also referred to as currency risk or exchange rate risk.read more, commodity price risk arises because of fluctuations in commodities like crude, gold, silver, etc. However, unlike foreign exchange risks, commodity risks affect not only multinational companies but also ordinary people like farmers, small business enterprises, commercial traders, exporters, and governments.

#4 – Equity Price Risk

The last market risk component is the equity price risk, which refers to the change in the stock prices of financial products. As equity is most sensitive to any change in the economy, equity price risk is one of the most significant parts of the market risk.

Market Risk Premium Formula

The market risk premium is one factor used to calculate the gauge market risk. 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 formulaMarket Risk Premium FormulaMarket risk premium refers to the extra return expected by an investor for holding a risky market portfolio instead of risk-free assets. Market risk premium = expected rate of return – risk free rate of returnread more is as follows:

The market risk premium has two significant aspects–the required substantial and historical premium. It is based on the investor community’s expectations in the future or on historical patterns.

The risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more is defined as the expected return without taking any risk. Most often US treasury rate as US sovereign riskSovereign RiskSovereign Risk, also known as Country Risk, is the risk of a country defaulting on its debt obligations. It is the broadest measure of credit risk and includes country risk, political risk, and transfer risk.read more 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 quoted at $1000. Suppose the investor expects the stock price to be hot at $1100 because of expected growth. The following is the calculation in Excel.

Calculation of Risk Premium will be –

Market Risk Premium = 11%

Advantages

Some advantages are as follows.

  • More often than not, financial products are sold to the investor community through aggressive marketing and presenting only the growth while completely ignoring the risks and downfalls. This is why 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 about the concept of market risk and its calculations, they could understand the financial products much better and decide if they suited them for such volatilities.The market risk premium, as explained in the example above, helps an investor calculate the real return rateReal Rate Of ReturnThe real rate of return is the actual annual rate of return after taking into consideration the factors that affect the rate like inflation. It is calculated by one plus nominal rate divided by one plus inflation rate minus one. The inflation rate can be taken from consumer price index or GDP deflator.read more. Even though the financial product might enjoy a lucrative return, the investor should gauge the investment in terms of the actual rate it provides. This can be calculated by taking into account the prevailing risk-free interest rate and inflation rate.

Disadvantages

Some disadvantages are as follows.

  • We cannot completely ignore them. An investor must be apt to understand what data to analyze and what data it should filter out. It can only be hedged, which comes with a cost and intensive calculations.Unlike credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower’s failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt’s principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more, which is very much counterparty specific, it affects all asset classes. It is very prone to recession or cyclic changes in the economy. And since it affects the whole market simultaneously, it is even more challenging to manage as diversification will not help.

Important Points

  • It is an integral 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 significant components here–time frame and 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. A confidence level determines how much risk an investor or portfolio managerPortfolio ManagerA portfolio manager is a financial market expert who strategically designs investment portfolios.read more can take. We express it in % terms like 95% or 99%.It is a statistical concept; hence, its calculations are cumbersome in numbers. The various tools/mechanisms used for calculation are – Value at risk expected shortfall, variance-covariance, historical simulation, and Monte Carlo simulationMonte Carlo SimulationMonte Carlo Simulation is a mathematical method for calculating the odds of multiple possible outcomes occurring in an uncertain process through repeated random sampling. This computational algorithm makes assessing risks associated with a particular process convenient, thereby enabling better decision-making.read more.Since market risk impacts the whole investor community irrespective of their credibility or the asset classAsset ClassAssets are classified into various classes based on their type, purpose, or the basis of return or markets. Fixed assets, equity (equity investments, equity-linked savings schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt), and alternative investments such as hedge funds and bitcoins are examples.read more they operate on, it is closely watched by regulators worldwide. In the last 25 years, we have witnessed four 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.

Conclusion

It is an integral part of any portfolio. It arises from the additional return an investor expects to generate from an investment. If you hedge, it can lead to better results and safeguard your losses when the market experiences downward cycles.

This has been a guide to Market Risk & its definition. Here we discuss the top 4 types of market risk, including interest rate, forex, commodities & equity along with examples, advantages, and disadvantages. You can learn more about financing from the following articles –

  • Types of Systematic RiskMarkdownCredit Risk TypesCalculate Residual Risk