What is a Market Risk?
Market risk reflects the potential of reduction in the investment value due to the interplay of varying market forces in the direction that can lead to losses for the business/ investors.
Significantly, the returns on the investment are often exposed to a range of market forces over which the business/investors do not possess any control. For instance, the financial crisis following the outbreak of coronavirus can be called systematic risk, affecting the overall market. Similarly, a change in the economic policy that can typically impact certain types of companies can also be an illustration of market risk as it can hurt the profitability and share price of such companies.
What do we understand by Market Risk in Stock Markets?
Political upheaval, natural disasters, war, pandemic, and fluctuations in macroeconomic indicators such as inflation, interest rate, fiscal deficit, recession, etc. can also overall impact the market and are thus considered as market risk.
Market risk can be the measure of the volatility of the overall stock markets across different asset types, industries, and sectors.
Such risks are typically associated with the impact of macroeconomic indicators, global factors and geo-political concerns on the financial market rather than being linked up to a company or an industry. Thus, they have the potential to affect a range of investment across different companies and sectors.
The market risk is also called a Systematic risk, which can only be minimised but not eliminated through diversification.
How does Systematic Risk Differs from Unsystematic Risk?
The total risk faced by the business can be categorised into Systematic Risk and Unsystematic Risk.
While Systematic Risk is the risk resulting from various external market variables that are uncontrollable and affect the entire market or segment, the Unsystematic Risk is mainly company or industry-specific and emerge from factors, which can be controlled by the necessary actions of the management.
Let us have a look at the key difference between Systematic and Unsystematic Risks.
How to Measure Market Risks?
Market Risk is generally measured using two methods which include Beta Value for the portfolio and value-at-risk (VaR) method.
Market Risks can be evaluated using Beta, which indicates the volatility of a particular asset/stock/portfolio viz-a-viz the overall market volatility. Beta, also referred to as financial elasticity, is used as a measure of systematic risk of an asset considering the market as a whole. Significantly, the beta value of the market is considered to be 1.
Beta only considers the systematic risk, thereby providing a clearer picture of the market risks attached to the investment portfolio. It is also used in the Capital Asset Pricing Model (CAPM) for measuring the expected return of a stock, considering the risk-free rate plus a premium on the systematic risk attached to the security.
Beta Value Analysis
Investors calculate the Beta for the portfolio to gauge the systematic risk of the portfolio in comparison to the overall market risk.
Value at Risk (VaR) is often used as a simplified technique of calculating the market risk. The measure encapsulates the entire market risk faced by a company. VaR is a statistical method, which answers three significant questions surrounding an investment decision, which are:
VaR measures the degree of risk as well as occurrence probability attached to the security over a specific time period. For example, VaR of 2% at the one-month time frame, with 95% confidence level indicates that there is only 5% chance that the value of the security will fall more than 2% in the one month.
Market risk using VaR is calculated through the following methods:
What are the ways to Hedge Market Risks?
Hedging is a risk management strategy generally undertaken for reducing portfolio exposure to the downside market risks. Hedging technique utilising financial derivatives involves holding offsetting position (long position vs short position) with the purpose to counterbalance losses from one position with profits from the another.
Following strategies can be undertaken to hedge against the market risks, depending on return expectation, financial situation and risk profile:
Futures Contract- It is a legal obligation on the two transacting parties to buy or sell assets and securities at a specific time in the future at a price earlier agreed upon by the parties. It prevents both the sides against the market risk resulting from the unfavourable price movement of the underlying security.
Options- The Options contract provide the buyer of the options an opportunity to buy or sell a security at a specified time at the predetermined and agreed upon price. While the buyer of the option has an alternative whether to execute the transaction or not, the writer (seller) of the option is obligated to sell or buy if the other party chooses to. Significantly, the buyer, therefore, pays an option premium for option rights granted.