It’s important to define a financial market before we can explain market risk. A financial market can be described as a place where goods are bought and traded. This “thing” could be anything of value. We use the terms “securities” and “financial instrument” to refer to things with a tradable price in the financial sector.
The stock market, for example, is where you can buy or sell shares of companies such as Apple and Tesla. On the forex market, currency pairs are traded. Other types of financial markets exist, such as equities and commodities. Markets are where securities of a certain kind are traded.
The financial markets are intrinsically valuable. Financial markets are made up of assets, and each asset has a value of its own. Apple, for example, has its intrinsic value. Stock markets have a certain inherent value.
It’s important to know that external factors can also affect the value of financial markets. Trading activity, political events, economic conditions, and global crises can all impact financial markets and, therefore, the securities held within them. Here comes market risk.
What is the market risk of trading?
Market risk is the risk that is more general and affects all markets. Let’s say that interest rates are going to skyrocket. This could have an impact on the stock market as a whole. This will impact the prices of Apple, Tesla, and other stocks in the market. It’s, therefore, a general risk that affects all assets, not just one.
A poor quarterly report from Apple, for example, could negatively impact Apple shares, particularly if the news was unexpected. However, Apple’s quarterly report is unlikely to affect Tesla’s share prices. Therefore, we can refer to the Apple quarterly report as a specific or individual risk.
Market risk is usually unfavourable and unpredictable. Market risk can be measured and mitigated. Usually, the risks you face are out of your control.
If, for example, there is a major event in foreign politics, this could affect the financial market. It’s impossible to predict something like this, and you have little control over when it occurs. You can diversify your portfolio to be better prepared for volatility in the market, such as when global events are unpredictable. You will have to accept market risk as a part of trading.
Four types of market risks in trading
Market risk can be classified into four different types:
Interest rate risk
Financial markets can be affected by a sudden change in interest rates. When interest rates rise suddenly or dramatically, people tend to spend less and save. When interest rates drop sharply, people are more likely to spend and save. This dynamic impacts a wide range of markets.
If interest rates are high and people don’t spend as much, fewer people will buy consumables, which hurts the stock price. People traveling less may affect oil prices, and currency markets can be affected by a drop in spending.
To take this one step further, high interest rates could discourage businesses from borrowing from banks. A company may also cut back on spending. There’s also the risk that higher interest rates will cause the currency to appreciate. The strong currency could encourage more foreign investment. More foreign capital entering the country will reduce the export power of local companies.
When interest rates drop, the opposite can also be true. The main point is that significant changes in interest rates can lead to volatility in the financial market. As you can see, even a seemingly small change in interest rate can cause a series of complex, interrelated events. These events will have an impact on the financial markets.
Exchange rate risk
Fluctuating exchange rates can also create market volatility, which is a risk. The purchasing power of a country is affected when the value of a particular currency changes. The reason for this is that currencies are linked by exchange economics. When one currency is stronger, the other must be weaker and vice versa.
When the USD is strong compared to the GBP, the latter is weaker than the former. To buy 1 USD, you need more GBP. If you take the opposite view, you will need less USD in order to buy 1 GBP.
These fluctuations can have a negative impact on countries and businesses. A strong GBP, for example, is not ideal if a UK-based company exports to the US. Why? Why? As we have said, a strong GBP will require more USD in order to purchase one GBP. So, the cost of products from the UK increases for US consumers.
The opposite is also true. When the GBP is strong, UK consumers get better deals on US products. The impact of exchange rates on purchasing power can have a significant effect on financial markets. Forex trading (i.e. The currency trading market is clearly at risk when exchange rates change dramatically. Foreign trade is also a threat to the stock markets. Commodity markets are also affected by foreign trade when commodities are priced in another currency.
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Equity Price RiskAn equity price risk occurs when the value of a security changes rapidly. This market risk is mainly focused on the stock exchange. The price of stocks is affected by many factors. However, there are only two main categories of market risk: systematic and non-systematic.
Systematic Risk
A sector or industry is considered to be at risk. If you own shares in Apple, and a crisis hits the tech sector or the mobile phone industry, your holdings would be affected. The crisis would impact the entire sector.
Unsystematic Risk
Unsystematic risks are specific to a company. If, for example, the CEO of Apple were fired due to misconduct, this could affect the value of the company. Unsystematic risks are not related to “the system” but rather to specific companies. It’s still a market risk that you need to take into account in conjunction with the general (i.e. systematic) risk.
Commodity Price Risk
The fluctuating value of commodities such as gold, corn or crude oil can have an impact on a wide range of financial markets. These fluctuations are usually linked to seasonal, political or regulatory changes. These are not the only factors.
Take a look at the price of crude in recent years. Oil prices have been volatile following global health concerns and protests against climate change. We can conclude that major events that impact daily life, such as travel restrictions, can influence the price of commodities.
Commodity risk will affect investments in gold and oil. These fluctuations can also affect other markets. If fuel prices are high, for example, haulage companies, airlines, and other markets can be affected, as can the supply chain.
Changes in one financial market can impact several seemingly unrelated markets. While they may not seem related at first, the market risks reveal that all financial markets, at least in some way, are interconnected.
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How to measure the market risk
After we have defined market risk and identified the four key areas to consider in this regard, we will now look at measurement. How can we measure market risks? Market risk can be measured in two ways:
Beta: This measure of market risk compares the stock’s performance to that of the market. This gives an idea of how volatile a stock is and whether or not it moves in line with the overall market.
VaR: A statistical method for assessing the market risk over time. This calculation takes into account the potential size of the loss, its probability and the possible time frame. When put into a VaR calculation, these variables give you a percentage chance of how much a security/portfolio/market might decline in value.
Beta and VaR are not perfect. They may be used in conjunction. It’s possible that you won’t use them because of an unexpected event or something beyond your control. While measuring market risks is important, this is not a precise science. Market risk cannot be eliminated. Market risk is something that’s always going to be present, so you need to accept its negative effects when they happen and factor it in.
Risk management strategies
In trading, diversification is often used to manage risk. Diverse portfolios are made up of a wide range of financial instruments. You might, for example, have shares in two companies, forex and oil stocks. This theory is that by diversifying your portfolio, you can even out the risk. When forex is in trouble, your entire portfolio may be bullish. The downturn in forex doesn’t have as much impact on your overall portfolio.
The market risks are too widespread to use this strategy. Interest rate risk can negatively affect other sectors when it hurts one. It’s a problem that affects many markets and, therefore, financial instruments. It doesn’t matter if you have a stake in stocks, forex or oil. The market risks are that if one suffers, they all could be in pain.
Hedging against market risk
What can you do if diversification doesn’t work to mitigate market risk? Hedging is a good way to protect yourself from market risks.
The strategy can reduce the negative swings but not eliminate them. Hedging can be defined as holding two or more positions simultaneously. Here, the goal is to counterbalance losses in one area by gaining in another.
You might have a long trade on USD/GBP in forex trading. To help mitigate currency risk, you take out a position to the short. You are buying and selling the same currency pair at the same time. This also means that you will make money whether the currency increases or decreases in value.
The losses will reduce or cancel out the gains and vice versa. In this case, you are taking two positions in order to be safe. You can protect yourself from swings either way if you want to. It’s important to know that you should not hedge for long periods.
Hedging is often seen as a short-term strategy because it can reduce your profits. You’ll hedge your positions when the market is at risk or when there is a high potential for risk. Then, you will stop hedging once volatility has decreased. Hedging will not eliminate market risks, as it is difficult to time things perfectly. It is a way to reduce your risk.
Trading is a complex process that requires traders to accept and understand risk. Although it is important to reduce the impact of market risk, you should also take away the message that this guide will never stop there.