Market Risk (Definition: What It Is And All You Need To Know)

What is Market Risk?

What are the market risk factors?

What are the essential elements you should know!

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What Is Market Risk

Market risk, also known as undiversifiable risk,  is a term used to refer to risk factors that may affect the entire market.

There are four primary sources of risk:

• Interest rate risk
• Equity price risk
• Foreign exchange risk
• Commodity risk

In essence, if an investor wishes to protect itself against “market risk”, it must use hedging strategies to reduce or lower the risk of loss possibly affecting a portfolio of investments.

You can consider this risk as a risk of loss associated with the movement or variation of prices in the market (price volatility).

Let’s look at the “market risk” definition.

Market Risk Definition

Market risk is also referred to as undiversifiable risk or systematic risk.

According to Investopedia, market risk is defined as:

In other words, market risks are risks of loss that can potentially affect an entire market at once.

Unlike “unsystematic risk”, market risks (systematic risks) can only be limited through hedging.

You cannot eliminate or reduce financial market risk through portfolio diversification.

Types of Market Risk

There are four types of market risks:

• Interest rate risk
• Equity price risk
• Foreign exchange risk
• Commodity risk

Let’s look at the market risk factors more closely.

Interest rate risk is a type of risk associated with fluctuations in the market rate of interest such as basis risk, options risk, term structure risk, and repricing risk.

Equity price risk is a type of risk associated with the fluctuations in securities prices.

When the value of the securities drop, the value of a portfolio of investments will drop as well.

Equity price risk can be divided into systematic risk and unsystematic risk.

An investor can protect itself against unsystematic risk by investing in a diversified portfolio whereas systematic risk will require the portfolio to be hedged against risk through the purchase of options.

Foreign exchange risk, or also known as currency risk, is a type of risk caused by currency exchange rate fluctuations.

Generally, investors who have investments in foregin countries may be exposed to the foreign exchange risk due to the fluctuations between the inverter’s local currency and the currency of the foreign investment.

Commodity price risk is the risk of loss caused by the fluctuation of commodity prices in the market.

There are many reasons why commodities prices fluctuate, namely, political factors, seasonality, technological development, and overall market conditions.

Market Risk Management 

Managing risk is an important part of business for many organizations and investors.

In fact, publicly traded companies in the United States are required to disclose and report how their business operations may be affected by the volatility in the capital markets.

For example, a company producing goods abroad may have significant exposure to foreign currency exchange risk whereas another company heavily dependent on commodities may be more at risk resulting from commodity price changes.

‘Market risk’ or ‘systematic risk’ can only be managed through hedging strategies.

On the other hand, ‘specific risk’ or ‘unsystematic risk’ which is directly tied to a particular stock or asset can be mitigated through portfolio diversification.

For instance, if you have a portfolio of many stocks, even if one company goes bankrupt, the profits you may realize on other stocks may compensate or offset the specific risk.

Some companies and investors will use the “value-at-risk” method (or VaR) to calculate and measure the market risk.

The VaR is a statistical analysis of risk where a financial model is put together to quantify an investment’s probability of loss.

Market Risk Example

Let’s look at some examples of market risk to better illustrate the concept.

Market risks are a type of risk that affects the performance of the entire market.

Here are some examples of sources of market risk:

• Recession
• Political uncertainty 
• Interest rate fluctuations 
• Natural disasters
• Terrorism 
• Fiscal deficit 
• Regulatory environment 
• Ease of doing business 

When there’s a natural disaster, an entire market can collapse or incur substantial losses.

A good example is when the markets incurred a sudden and drastic loss due to the COVID-19 pandemic. 

The source of the risk (COVID-19) affected the performance of the entire market.

Systematic Risk Takeaways 

So, what is a market risk?

What is the definition of market risk?

Market risk is the risk of financial loss caused by the adverse movement of stock prices or volatility in the market.

Let’s look at a summary of our findings.

Define Market Risk

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