Market risk, also called systematic risk, refers to any uncertainty associated with an investment decision. Price volatility is often caused by unanticipated changes in factors that affect the entire financial market.

The performance of the market is what determines the level of systemic risk. Investors should keep an eye out for macro-variables in the financial markets, including inflation, interest rates and fiscal deficits.

Summary

• Market risk, also called systematic risk, refers to any uncertainty associated with an investment decision.
• There are different types of risks in the market, including interest rate risk and commodity risk. Currency risk is also a type of risk.
• Professional risk managers use statistical methods, such as Value at Risk (VaR) and the beta coefficient, to identify possible losses.

 

Market Risk: Different Types

1. Interest Rate Risk

The central bank’s monetary policies can cause unanticipated changes in interest rates. In the long term, the yields on securities offered across all markets will be equalized by adjusting the market demand and supply. A rise in rates will cause the price of the security to fall. This is mostly associated with fixed-income securities.

Take, for example, a sovereign bond that offers a fixed coupon of 6% per annum on the principal value. If the market interest rate increases to 8%, the demand for the bond will decrease by 6% after the price falls, which causes the yield to rise until it equals 8%. A decline in market interest rates will also lead to an unexpected gain in the price of the security.

2. Commodity Risk

Oil or food grains are essential commodities for every economy. They also complement the production of many goods because they can be used as indirect inputs. Commodity prices’ volatility can affect the overall performance of the market and often cause a supply-side crisis.

These shocks can lead to a drop in stock prices, performance-based dividends, and a company’s ability to honour the value of the principal.

3. Currency Risk

Exchange rate risk is another name for currency risk. It is the potential for a decrease in an investor’s return due to the depreciation in the value of the local currency. When making an international investment, the risk is always taken into account.

Many emerging market economies keep high reserves of foreign currency to reduce the risk of losing out on foreign investments. They do this to ensure that any depreciation is negated through the sale of the reserves.

4. Country Risk

Macro variables that are beyond the control of the financial markets can affect the level of return on investment. These include political stability, fiscal deficit, natural disaster proneness, regulatory environment, and ease of doing business. When making international investment decisions, it is important to consider the level of risk associated with these factors.

How to mitigate market risk

Diversification can’t mitigate risk as it is spread across the market. However, hedging can minimize exposure to risk. Investors may not earn the expected returns even after applying rigorous fundamental and technical analyses to the specific investment option.

Volatility, or the absolute/percentage spread in prices, is a good indicator of market risk. Professional analysts use statistical risk management methods such as Value at Risk (VaR).

VaR is a method for evaluating market risk. It is a standard risk management technique that uses statistics to quantify a stock’s or portfolio’s potential loss and probability. The VaR method is popular, but it relies on some assumptions that limit its accuracy.

A beta coefficient allows an investor to gauge a portfolio’s volatility or the market risk it poses in comparison with the rest of the market. Capital asset pricing (CAPM), which is used to calculate an asset’s expected return, is also included.

Additional Resources

We thank you for taking the time to read CFI’s Market Risk guide. These additional resources can help you to become a top-notch financial analyst and achieve your career goals.

• Idiosyncratic risk
• Fama-French Three-Factor Model
• Systemic Risk
• Vasicek Interest Model
• View all Wealth Management Resources