What Is Market Risk?
Market risk is the possibility that an individual or other entity will experiencelosses due to factors that affect the overall performance of investments in the financial markets.
Key Takeaways
- Market risk, or systematic risk, affects the performance of the entire market simultaneously.
- Market risk cannot be eliminated through diversification.
- Specific risk, or unsystematic risk, involves the performance of a particular security and can be mitigated through diversification.
- Market risk may arise due to changes to interest rates, exchange rates, geopolitical events, or recessions.
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Understanding Market Risk
Market risk and specific risk (unsystematic) make up the two major categories of investment risk.Market risk, also called systematic risk, cannot be eliminated through diversification, though it can be hedged in other ways. Sources of market risk include recessions, political turmoil, changes in interest rates, natural disasters, and terrorist attacks. Systematic risk, or market risk, tends to influence the entire market at the same time.
This can be contrasted with unsystematic risk, which is unique to a specific company or industry. Also known as nonsystematic risk, specific risk, diversifiable risk, or residual risk, in the context of an investment portfolio, unsystematic risk can be reduced throughdiversification.
Market risk exists because of price changes. The standard deviation of changes in the prices of stocks, currencies, or commodities is referred to as price volatility. Volatility is rated in annualized terms and may be expressed as an absolute number, such as $10, or a percentage of the initial value, such as 10%.
Publicly traded companies in the United States are required by the Securities and Exchange Commission (SEC) to disclosehow their productivity and results may be linked to the performance of the financial markets. This requirementis meant to detail a company’s exposure to financial risk. For example, a company providing derivative investments or foreign exchange futures may be more exposed to financial risk than companies that do not provide these types of investments. This information helps investors and traders make decisions based on their own risk management rules.
Other Types of Risk
In contrastto the market’s overall risk, specific risk or unsystematic riskis tied directly to the performance of a particular security and can be protected against through investment diversification. One example of unsystematic risk is a company declaring bankruptcy, thereby making its stock worthless to investors.
The most common types of market risks include interest rate risk, equity risk, currency risk, and commodity risk.
- Interest rate risk covers the volatility that may accompanyinterest rate fluctuationsdue to fundamental factors, such as central bank announcements related to changes in monetary policy. This risk is most relevant to investments in fixed-income securities, such as bonds.
- Equity risk is the risk involved in the changing prices of stock investments.
- Commodity risk covers the changing prices of commoditiessuch as crude oil and corn.
- Currency risk, or exchange-rate risk, arises from the change in the price of one currency in relation to another. Investors or firms holding assets in another country are subject to currency risk.
Managing Market Risk
If you are investing, there is no single way to completely avoid market risk. But you can use hedging strategies to protect against volatility and minimize the impact that market risk will have on your investments and overall financial health. For example, you can buy put options to protect against a downside move when targeting specific securities. Or, if you want to hedge a large portfolio of stocks, you can utilize index options.
Use a variety of these strategies to manage market risk and protect your portfolio.
Dollar-cost averaging won’t protect you against market risk. But investing the same amount of money on a regular schedule can help you ride out ups and downs in the market, taking advantage of periods of both low costs and high returns.
Study Currency Profiles
If you are investing in foreign markets, pay attention to the currency profiles of the companies in which you invest. Industries that import more, for example, will be impacted by changes to the local currency. Industries that export more will be affected by changes to the value of the euro or dollar. Allocate your assets across a variety of industries to mitigate risk, and invest in markets and companies backed by strong currencies.
Watch Interest Rates
To manage interest rate risk, pay attention to monetary policy and be prepared to shift your investments to account for interest rate changes. For example, if you are heavily invested in bonds and interest rates are rising, you may want to tweak your investments to focus on shorter-term bonds.
Maintain Liquidity
When markets are volatile, you may have trouble selling or buying an asset within your price range, especially when you need to exit a position in a hurry. If the market is crashing, liquidity may be difficult no matter what type of stocks you buy. Under more normal conditions, though, you can maintain your liquidity by sticking with stocks that have low impact cost (the cost of a transaction for that stock) to make trading easier.
Invest in Staples
Some industries tend to do well even when the overall economy is poor. These tend to be utilities and businesses producing consumer staples. That’s because no matter what the economy is doing, people still need to turn their lights on, still need to eat, and still need toilet paper and toothpaste. By keeping some of your money in staples, you can still see returns in a recession or a period of high unemployment.
Think Long Term
No matter where you invest your money, it is impossible to fully escape market risk and volatility. But you can manage this risk, and escape much of the impact of volatile markets, by using a long-term investing strategy. You may want to make small tweaks in response to changes in the market. But don’t upend your entire investing strategy because a recession hit or a currency changed value.
In general, short-term traders are more impacted by volatility. By contrast, over time, volatility tends to even out over time. By approaching your investing systematically, and sticking with a long-term outlook and strategy, you are more likely to see your portfolio bounce back from the impact of market risks.
Measuring Market Risk
To measure market risk, investors and analysts often use the value-at-risk (VaR) method. VaR modeling is a statisticalrisk management method that quantifies a stock’s or portfolio’s potential loss as well as the probability of that potential loss occurring.While well-known and widely utilized, the VaR methodrequires certainassumptions that limit its precision.
For example, it assumes that the makeup and content of the portfolio being measured are unchanged over a specified period. Though this may be acceptable for short-term horizons, it may provide less accurate measurements for long-term investments.
Value at Risk (VaR)
VaR is a statistical measure that calculates the maximum potential loss a portfolio could experience over a given time period at a certain level of confidence. So, a VaR of 95% suggests that there is a 95% chance that the portfolio would not lose more than the calculated amount over the given time period.
- Thehistorical methodfor computing VaR looks at one’s prior returns history and orders them from worst losses to greatest gains—following from the premise that past returns experience will inform future outcomes.
- The variance-covariance method, also called theparametric method, does not look backward but instead assumes that gains and losses arenormally distributed. Potential losses are framed in terms ofthe number of standard deviationsfrom the mean.
- Monte Carlo simulation uses computational models to simulate projected returns over hundreds or thousands of possible iterations. Then, it estimates the chances that a loss will occur to compute the VaR—say, what the maximum loss would be 5% of the time.
Risk Premium
The equity risk premium (ERP) is a measure of market risk that reflects the excess return that investors demand for investing in stocks over and above the risk-free rate of return. In other words, it is the implied additional compensation that investors require to hold an investment in the broader stock market, which is inherently riskier than holding a risk-free asset like U.S. Treasuries.
The ERP is calculated by subtracting the risk-free rate of return (usually the yield on a short-term or midterm government bond) from the expected return on the stock market. For example, if the expected return on the stock market is 10% and the risk-free rate is 2%, the ERP would be 8%.
The difference between the broadermarket risk premium (MRP)and the equity risk premiumcomes down to scope. The ERP is specific to the stock market, while the MRP is the additional return that’s expected on a diversified portfolio of investments held among various asset classes that is above the risk-free rate.
Beta is another relevantrisk metric that measures the relativevolatility or market risk of a security or portfolio compared to the market as a whole. It is used in the capital asset pricing model (CAPM) to calculate the expected return of an asset. A beta of 1.0 indicates a stock has market risk identical to the broader S&P 500, while a beta greater than 1 means that the asset is more volatile than the market. Beta can be used to estimate the market risk of a portfolio by calculating the weighted average beta of its constituent assets.
What’s the difference between market risk and specific risk?
Market risk and specific risk make up the two major categories of investment risk.
Market risk, also called systematic risk, cannot be eliminated through diversification, though it can be hedged in other ways and tends to influence the entire market at the same time.
Specific risk, in contrast, is unique to a specific company or industry. Specific risk, also known as unsystematic risk, diversifiable risk or residual risk, can be reduced through diversification.
What are some types of market risk?
The most common types of market risk include interest rate risk, equity risk, commodity risk, and currency risk.
Interest rate risk covers the volatility that may accompany interest rate fluctuations and is most relevant to fixed-income investments.
Equity risk is the risk involved in the changing prices of stock investments.
Commodity risk covers the changing prices of commodities such as crude oil and corn.
Currency risk, or exchange-rate risk, arises from the change in the price of one currency in relation to another. This may affect investors holding assets in another country.
How is market risk measured?
A widely used measure of market risk is the value-at-risk (VaR) method. VaR modeling is a statistical risk management method that quantifies a stock’s or portfolio’s potential loss as well as the probability of that potential loss occurring. While well-known, the VaR method requires certain assumptions that limit its precision.
Beta is another relevant risk metric that measures the relative sensitivity of an asset to broader market movements. The equity risk premium (ERP) is the implied expected return that investors demand while holding market risk in the stock market, above and beyond that of the risk-free rate of return.
Is inflation a market risk?
Inflation can contribute to market risk by impacting business performance, consumer behavior, and investor confidence. Monetary policy may be used to counter inflation through higher interest rates, which can in turn lead to a recession, causing the entire market to slow down.
This is different from inflationary risk, or the possibility that the rising prices caused by inflation could outpace the returns from your investment.
Inflationary risk is not a specific type of market risk because it doesn’t impact the overall performance of financial markets. However, it is a type of investing risk. Diversification, investing early to take advantage of compound interest, and investing more aggressively when you are younger can all help minimize inflationary risk.
The Bottom Line
Market risk is the chance of incurring losses due to factors that affect the overall performance of financial markets. Events such as changes in interest rates, geopolitical events, or recessions can bring on what is known as the pain trade. It is called systematic risk since it cannot be eliminated through diversification. Specific risk, on the other hand, is unique to a particular stock or industry sector and can be minimized through diversification.
Market risk can be measured using methods such as the value-at-risk (VaR) method, risk premia, or beta coefficient.
