Market Risk – Protect Your Capital
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Market risk is also known as risk of loss which occurs due to factors affecting the asset class or the entire market. Therefore, the whole scenario of market risk is unpredictable because it affects all asset classes within a trade market.
By hedging a portfolio, an investor can smoothly mitigate risk to prevent any bid losses. Through the below guide, we will discuss different types of market risks, how you can measure them and what steps can be taken to avoid market risk.
What is a Market Risk?
Market risk is a risk of change or a decrease in the value of investments. And this change will occur due to uncontrollable market factors.
When we talk about uncontrollable market factors, this includes changes in government policies, depression or recession, natural calamities, political unrest, disaster, or terrorism.
Market risk is also known as Systematic Risk in which the entire financial market is affected. An organisation or any individual does not control the emergence of any risk in a trade market. But it can be curtailed through different trading strategies.
In addition, continuous control and monitoring of trading activities by traders play a vital role. This will enable them to keep a track record on macro variables, including the interest rate and inflation, to minimise the market risk.
A guide on different types of market risk
Market risk is categorised into different types, which are discussed below:
1. Interest Rate Risk
Interest rate risk generally happens due to inevitable unanticipated fluctuations happening in interest rates. These fluctuations can occur because of monetary policy measures under the custody of the central bank.
Any increase in the commodity rate will also cause a decline in the security price. This whole scenario is linked with fixed-income securities.
2. Commodity Risk
Oil and food grain are the few necessities for any economy. Moreover, it often complements the overall production process of various foods due to its utilisation as the indirect inputs.
Any volatility appearing in the commodity prices will also affect the overall performance of the trade market. This effect can be in the form of a supply-side crisis.
A decline in a commodity value is not just restricted to the effects on performance dividends or stock prices. But it even reduces the company’s overall ability to gain more value and a high reputation.
3. Currency Risk
Currency risk is popularly known as exchange rate risk. It occurs due to exchange-rate fluctuations between various currencies. These exchange rates are not country-specific and generally depend on the introductory rates of all currencies worldwide.
Investors investing in foreign countries or the international market are more inclined towards the currency risk. But trading in the global market can even get affected by inevitable currency fluctuations. This is because their outflow and net inflow will somehow differ based on changes in currency rates.
4. Country Risk
Various macro variables outside the financial market’s control can affect the entire level of return because of investment. This includes fiscal deficit level, political stability, business performance, regulatory environment, and so on.
When deciding on international investment, all the factors mentioned above should be considered to determine the level of risk.
5. Equity Risk
Last we have equity risk, which is basically about the possibility of specific changes in prices of stocks or stock indices. This happens due to certain factors, including new product launches, discovery or a new invention, change in government laws or regulations, significant epidemics, or general economic environments!
Why should you take market risks?
It would be a crazy decision to invest your money into something lost or have some risky outcomes. Risk factors generally depend on what your primary goals are and what alternatives you are choosing.
When considering a market risk, a trader should also consider the tradeoff between reward and risk. By taking a little risk, you will probably get little in return.
But by taking a bigger risk, it is evident that the return will be in the form of a larger reward.
Therefore, traders adopt the market risk just because it has a high potential for gaining maximum returns. But, unfortunately, there is not even a single guarantee that you will not get those returns, nor can you identify when the market moves up or down.
But at the end of the day, you can still hope to be rewarded for taking considerable risks in the market.
What is the difference between market risk & company-specific risk?
The main difference between market risk and company-specific risk is discussed in the table below:
|Market Risk||Company-specific Risk|
|It affects all investments within a trade market||It does not affect all the investments in a trade market|
|It cannot be eliminated through diversification||Easy to be reduced through diversification|
How to measure market risk?
Market risk can be measured through two different techniques, namely:
- VAR Method
- Beta Coefficient
Now let’s discuss each one of them in detail below:
1. VAR Method
The first method to measure market risk is the VAR method, also known as value-at-risk. It is a statistical method for managing market risk.
The VAR Method also calculates the probable loss which a portfolio or the stock is potentially making. The measure of VAR is the percentage form or the price unit, which is easy for the trader to understand and interpret.
The VAR method can be applied to various investment assets, including derivatives, bonds, and stocks. A trader can assess the rising profit potential of multiple investments, after which they can plan accordingly on how much they should invest in futures trading.
In addition, a VAR method is also based on certain limitations. This method involves the calculation of risk and returns on individual assets. It often highlights the correlation between the assets to understand the future price movements.
It might become a little complicated to calculate the VAR if the number of assets is large and is diversified in a trading portfolio. Plus, it even assumes that the trade portfolio will remain unchanged for a specific period.
The VAR method is suitable for short-term investments and might display some unreliable results in long-term investments. This is because, in a long-term investment, portfolio content is always changing.
2. Beta Coefficient
Beta coefficient measures market risk or volatility of an investment or the portfolio compared to any other trading market. It plays a vital role in the Capital Asset Pricing Model (CAPM) and will describe the asset return towards a systematic risk.
Any investment with the Beta Coefficient equals “1,” which is highly volatile as the trade market. However, both stock and securities are strongly correlated, and they behave in sync within the trade market.
If the beta value is greater than “1,” then it means that the security or investment has high volatility compared to the market. In this way, in a rising trade market, it can rise quickly and without facing any huge risk.
Similarly, if the beta value is less than “1”, the security or investment is less volatile than the trade market. Therefore, investment is the safest option with less risk. But its return factor is equally limited.
Two best ways to manage market risk
We all know that market risk is quite unpredictable. A few ways can be adopted to manage market risk both in and out of the trade market to improve your chances of gaining high potential. Those two primary ways are:
1. Different markets will move differently
Diversification is another significant way to manage market risk. For example, it would help if you considered spreading your invested money into lots of different investment types to keep yourself away from future market risk.
It might be possible that some investments won’t show the great results you have desired. And sometimes, few investments start to move in the opposite direction.
By having a mixture of excellent investments, you can surely keep yourself away from market risk problems in the future.
Always know that diversification is an essential tool and not a magical one. It won’t bring drastic results for you in just one night. On the other hand, sometimes the loss is so big enough that you start feeling uncomfortable with your portfolio.
You should accept the reality that different markets will perform differently, and they have a diverse scenario to bring loss and profit for you.
2. Flip through the history and get help
We all know that time will heal everything, and it’s an undeniable reality! So if you think the market will go up within the long term, it is better to manage market risk by simply investing in long-term trading.
Sometimes, keeping yourself updated with the latest market trends daily can be a lot of troubling. As a result, you will notice a lot of threats and bumpy roads coming your way.
Even though the trade market has noticed so many threats and risks, it is still rising with time, with significant potential profits. You can flip through history and see what threats are visible during uncertainty, war, depression, or inflation conditions.
Strategies and tips on how to avoid market risk
The whole situation of facing market risk is troublesome for a few traders because they get to know something terrible each time.
As soon as the market goes down, the constant news headlines and how the prices start to fall will make you anxious. It is not fun at all!
Even if the market is rising quickly, it still creates anxiety among traders where they put their efforts to meet the latest market trends and price movements.
There is no doubt that market risk is not less than an evil to gain high growth over long-term investment. In the past few years, riskier investments have given a massive return as compared to safer investments.
There is no guarantee that the future will stick to what the past was. On the contrary, it keeps on changing because the world of trade market is unexpected. As a trader, you can experience both the stages of loss and profit.
By avoiding market risk, you are moving into a state where you expose yourself to inflation risks.
To manage market risk, you should ask yourself how much and what level of risk you can handle during your trading journey. This can be based on when you are inside the market or are out of it. First, figure out the appropriate level and then plan some basic strategies.
What are the best alternatives to market risk?
Apart from market risk, some unsystematic risks can affect a particular company. However, these risks are associated with an individual firm and can be easily reduced through diversification.
In addition, unsystematic risks can easily be removed by holding numerous financial securities. Two major unsystematic risks are:
1. Business Risk
Business risk is also known as operational risk. This risk can occur due to specific natural changes happening in a business. And these changes can eventually reduce the potential of a company’s profit.
2. Financial Risk
Financial risk is a form of risk which a trader faces through its sources of investment or financing. This includes the use of leverage or debt.
Through financial risk, a company is put into a risk to survive by repaying interest or principal.
Regulations for market risk
There are quite a few regulations associated with the disclosure of market risk towards traded investments. The Securities and Exchange Commission has made it compulsory for all trading companies to reveal their market risk exposure for the coming traders.
In the annual reports, companies must mention how the financial market exposure and volatility will impact the market risk.
In short, when a trader is investing for the first time, they are highly concerned about the market risk. And a market risk can easily be identified once you notice that the asset’s value has started to decrease.
We have already explained to you in the guide about different types of market risk and how they can affect your invested amount. So, measure the market risk accordingly and see how you can avoid it to achieve maximum profits.
All the Best!
Jason Morgan is an experienced forex analyst and writer with a deep understanding of the financial markets. With over 13+ years of industry experience, he has honed his skills in analyzing and forecasting currency movements, providing valuable insights to traders and investors.
Forex Content Writer | Market Analyst