Market risk

Key Takeaways

  1. Market risk is losses in investment faced by the investor due to fluctuations in the market, like economic slowdown or natural disaster, etc.
  2. Market risk affects the overall performance and productivity of the economy.
  3. The difference between the expected rate of return and the risk-free rate is known as the market risk premium.
  4. 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.

Equity Risk – a risk that changes index or stocks prices

Causes of market risk / What are market risk factors?

Many factors cause the market risk. Such factors can be a global pandemic, global recession, economic slowdown, natural disasters, changes in monetary policy, etc.

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.

The risk cannot be diversified as it impacts the entire market, but it can be hedged for minimal exposure. As a result, even when comprehensive fundamental and technical analyses are applied to a certain investment option, investors may still not see the projected returns.