“Market risks” are risks specifically related to investments. These risks are defined by the behavior of the market overall, and can be caused by factors unrelated to your line of business. Really, any market fluctuations in any area might potentially affect your company’s investments.
Market risk also refers to risks that are inherent to investments, in the sense that some amount of uncertainty will always be at play. A high level of market risk can be dangerous, but that high risk also allows for a high rate of return from those same markets.
While it is impossible to eliminate market risk entirely, you can manage your investments to minimize loss, making it easier for your company to reach its financial goals.
What Is Market Risk?
Market risk, also known as systematic risk, arises from factors and uncertainties affecting the financial markets (particularly the overall performance of investments) and can result in losses. Changes to exchange rates, interest rates, economic downturns such as recessions, and geopolitical events are some examples of factors that contribute to market risk.
Types of Market Risks
Interest rate risk
This risk is caused by changes in interest rates. Volatility in interest rates can cause the value of fixed-rate investments to decline. For example, a treasury bond you bought in 2020 with a very low interest rate is worth less in 2023, since new bonds now carry higher interest rates. Hence maintaining awareness of interest trends is advisable for all investors.
Country risk is defined by the economy of wherever you are making investments and the economic or political stability of that country. This stability can be affected by political unrest, natural disasters, international relations, disease outbreaks, war, and similar large-scale events.
Currency risk depends on foreign exchange rates. If the value of the currency used to make an investment goes down, the value of the investment will also fall. Or if you owe money in a foreign currency, the true cost of paying off the debt could rise or fall depending on how that currency moves in relation to other currencies.
Commodity risk is caused by staple products that are so key to the economy that any volatility in their cost can affect the entire market. This usually refers to products in the energy or agriculture sectors, such as oil, gas, soybeans, or orange juice.
Liquidity risk refers to how easily you can convert an investment into cash. An investment with high liquidity risk will be difficult to sell off (either there are few buyers, or nobody is sure what price to pay for the investment), while an investment with low liquidity risk will be relatively easy to sell for market rate.
Examples of Market Risks
Here are a few examples of market risk:
- You invest in a bond and interest rates rise, leading to a reduction in the bond’s value. (Risks associated with changes in interest rates).
- You invest in a foreign stock and the value of the currency in which it’s denominated falls. If you convert the investment back into your home currency at this time, you’ll lose money. (Risks associated with changes in exchange rates between two currencies)
- You invest in a commodity-based fund, after which the price of the underlying commodity falls. This causes the value of your fund to decrease. (Risks associated with changes in commodity prices like gold, oil, and agricultural products)
- The value of your stock falls when the overall market falls. If you sell it during the downturn, you lose money. (Risks associated with changes in the stock market)
- The overall stock market experiences a downturn when the economy enters a recession, causing you to lose money if you have invested in stocks. (Risks associated with market conditions affecting the overall market like natural disasters and economic conditions)
What Is the Difference Between Market Risk and Business Risk?
Business risk arises from internal risk factors that are unique to a particular business and can lead to potential losses. These factors may include competition, regulatory changes, supply chain disruptions, or changes in customer behavior and preferences. Since these risks are mostly internal, they can be influenced by factors that are within the control of the business.
Market risk is caused by external factors that affect all businesses operating in the same market. The key difference between market risk and business risk is that the former is common to all participants in the market, while the latter is specific to each individual business due to its internal factors.
How Do You Measure Market Risk?
You can measure market risk using various metrics, but the most preferred method is Value at Risk (VaR), a statistical measure that quantifies potential losses and the probability of these losses occurring for a portfolio or stock. That said, this method isn’t foolproof; it’s based on assumptions that may affect the accuracy of results.
Another way to measure market risk is using the risk metric known as beta. Beta measures the sensitivity of a specific stock or investment to the broader market. The equity risk premium (ERP) is the extra returns you can demand for taking on the risk of investment in the stock market rather than making a risk-free investment (say, in an insured bank savings account).
What Are Some Methods for Managing Market Risk?
Determine your risk tolerance
Before developing a market strategy, first decide how much risk you’re willing to take. Investing can be complex, and beginners may not know how to navigate the market successfully. Some companies use VaR to measure how likely an investment is to result in a loss, but this only helps your investment decisions if you’ve determined in advance what risks you are comfortable making.
Diversify your assets
A simple strategy for managing your risk is to avoid making all of your investments in the same sector. Diversification of your asset classes can assure that a loss in one area will be offset by stability or gains in others. This isn’t a guaranteed defense against risk, as any market shifts can affect your investments; but strategically choosing your investments and derivatives can help protect you from truly devastating loss.
Hedge your investments
Hedging is an investment strategy that minimizes potential loss if a stock value falls. This is done by purchasing an option, which gives you the right to sell your stock at an agreed-upon price if its value begins to dip. You may not see as high of a return on your investment as you would otherwise, but it’s an appealing method for those who do not wish to take on an extreme amount of risk.
Be aware of market changes and how fluctuations might affect your investments. You won’t be able to predict the future with perfect accuracy, but staying up to date on the stock market and its movements can help you know when to buy, sell, and hold.
Wait it out
If the value of your stock dips, don’t panic. Minor changes in the market may have temporary effects that your accounts will be able to weather over time. Before selling, observe the trends the market is exhibiting overall and determine whether you can afford to hold on to a long-term investment.
ROAR Helps Businesses Minimize Risks
All businesses must accept some risk to grow, so it’s critical that your business prepare for potential risks – not only from the stock market, but also from cyber threats, compliance issues, and any other factor that could disrupt operations and delay your company’s progress. With so much at stake, it can be difficult to know where to begin; how can you create a centralized database of all of your risk and risk prevention efforts?
The RiskOptics ROAR Platform is the answer. This integrated software gives you a complete view of your company’s entire risk and regulatory compliance landscape with all the information you need right at your fingertips. By providing a single source of truth for your risk management, ROAR creates a centralized framework for your risk management strategy.
Schedule a demo today and learn more about how ROAR can be a part of your company’s risk solution.