There are many different types of risk that impact market risk. Understanding more about each of these specific risks can give a better understanding of market risk.
- Commodity risk: Commodity risk is the risk to consumers or the market related to the change in price of commodities, such as oil. As oil prices increase, it can lead to an increase in inflation as the cost to produce and move products typically increases.
- Interest rate risk: Interest rate risk is the risk to an investment or investor from the changes in interest rates. Interest rates can increase or decrease, and these rate movements can have positive or negative impacts on investment. Bonds are investments that are subject to interest rate risk. If an investor owns a $1,000 face value bond with a 5% annual coupon payment and interest rates increase by 1%, the market value of this bond will decrease as investors can now purchase a $1,000 face value bond with a 6% annual coupon payment.
- Currency risk: Currency risk, otherwise known as financial exchange risk, is a risk present for investors or companies who operate or invest across multiple currencies. The risk of an increase or decrease in the currency exchange rate is known as currency risk. An example of this would be a company that produces tractors in the US and sells them in China. If the company needs to receive $50,000 in payment for their tractors but gives the price to their customer in Yuan, the business has created currency risk. If the value of the Yaun to the US dollar increases after the company gives their customer a price, when the company converts the Yaun to US dollars, they will have less than $50,000.
- Equity risk: Equity risk is the risk related to the price increases and decreases of a specific stock or company.
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Understanding how market risk is measured is as important as understanding what goes into market risk. One of the most common ways to measure stock market risk is using Value at Risk (VaR). VaR measures how much a specific portfolio is at risk of losing as well as what the probability is of the loss event. While this calculation is not an exact science, it gives an investor a better understanding of their specific portfolio risk or the market risk as a whole. Some of the main reasons value at risk is used is because it is easy to understand, applicable to multiple different types of investments, and is a widely used standard for quantifying risk.
Value of Risk Formula
There are three main ways of calculating VaR, and which value of risk formula is used often depends on the type of investment being evaluated.
- Historical method: This is the least complex method for calculating VaR. To complete this calculation, the historical returns for a specified period of time, such as 100 days, at a given confidence level, such as 95%. Using this method, the main factor taken into consideration is the historical returns of the investment. This is the simplest method to calculate and explain, but the method can be slow to react to changes in the overall investment.
- Parametric method: The parametric method is considered the more quantitative approach to calculating VaR. In this method, the user must first calculate the standard deviation of the portfolio. To do this, historical price movements of the portfolio are used to determine maximum loss estimates. These estimates can be calculated using the standard deviation of the portfolio.
- Monte Carlo method: Using the Monte Carlo method, or Monte Carlo simulations, a computer program performs thousands of simulations to determine possible returns and outcomes. From those simulations, a prediction will be made within a specified confidence level of a range that can be expected for a specific investment.
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Market risk management is an important aspect of investing. While market risk can't be diversified away, some of the market risk can be hedged by purchasing assets that typically perform well when the market is not performing well. One example of this is purchasing gold. Gold has historically been considered a market hedge because it is a store of value. When certain market risks are present, such as high inflation, the market tends to decrease in value. At the same time, gold typically increases in value.
Another way more sophisticated investors hedge against market risks is by short selling securities or exchange traded funds. When an investor does a short sale, they are betting the investment will decrease in value. The more the investment decreases in value, the more money they make. This is similar to purchasing insurance because if the investment increases, the original investment increases, but the short sale decreases in value. If the investment decreases in value, the short sale increases in value. Short sales are not right for all investors and are just one way to hedge against market risk.
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It is very easy to identify past historical events that resulted in market risk. Two of the largest events that led to overall market risk were the global financial crisis of 2008 and the COVID-19 pandemic in 2020. In 2008, when the global financial system started to fall, the market was holistically impacted, and global markets saw a substantial loss in value. The market risk was so bad for this event that it led to a recession, often times referred to as the Great Recession. During the time known as the Great Recession, only ten stocks had a positive return. This example shows that normal methods of diversification cannot always protect an investor from market risk. The global economy saw similar price fluctuations during the beginning of the COVID-19 pandemic in March 2020. Fortunately, by the end of the year, the market had regained some of its momentum as a result of stimulus packages and an increase in consumer savings.
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There are two main types of risk in a portfolio of investments. Market risk, which impacts the market as a whole, and specific risk, sometimes referred to as unsystematic risk, which is the risk a specific investment brings to the portfolio. While market risk cannot be diversified, specific risk is able to be diversified. By purchasing investments that do not have a strong correlation, an investor is able to reduce the risk of owning a specific investment. Diversification is important in a portfolio because if one investment is not performing well, one of the other non-correlated investments is likely to be performing well.
Taking the average of multiple investments gives the overall performance of the portfolio. For example, a specific portfolio owns five stocks. These five stocks are comprised of blue-chip stocks from five different non-correlated industries. If the stocks are equally weighted and have the following returns, the overall return of the portfolio would be 4%:
- Company A: 10%
- Company B: 5%
- Company C: -5%
- Company D: -2%
- Company E: 12%
Investing in a diversified portfolio protected the overall rate of return from being negative, even though two of the investments purchased had a negative return for the year.
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Understanding how market risk, the risk that cannot be diversified away because it is risk that impacts the entire market, impacts investments is an important topic for all investors to understand. There are many types of market risks that can impact investors, such as commodity risk, interest rate risk, currency risk, equity risk, and many others. There are many ways to calculate market risk, and Value at Risk (VaR) measures how much a specific portfolio is at risk of losing as well as what the probability is of the loss event. To calculate VaR, the investor has to determine the best method for their specific case. They can choose the historical method, parametric, or Monte Carlo simulation methods. Because market risk cannot be diversified, it is important to understand how much risk is present and ways to manage the risk. It is also important to understand how specific risk, sometimes referred to as unsystematic risk, which is the risk a specific investment brings to the portfolio, impacts an overall portfolio.
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Frequently Asked Questions
What does market risk affect most?
Market risk most affects investment portfolios. As this risk cannot be diversified away, investors need to find ways to hedge market risk.
What are the types of market risk?
Three types of market risk are commodity risk, interest rate risk, currency risk, and equity risk. Each type of risk impacts the market in a different manner.
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