Market risk explained
Trading comes with unavoidable, and sometimes unpredictable, risks. Here we explain market risk, discuss the different types, and show you how to measure and hedge against them.
What is market risk?
Market risk is the risk associated with losses due to unfavourable price movements that affect the market as a whole. These markets range from commodities to cryptocurrencies, any market carries risk. Because market risk affects the entire market, and not specific assets, it can’t be avoided through portfolio diversification.
Types of market risk
Market risk depends on the type of security being traded, as well as the geographical boundaries of the trade.
Interest rate risk
If interest rates increase or decrease suddenly, market volatility is likely to increase. Interest rate changes affect asset prices because the level of spending and investment across an economy will increase or decrease, depending on the direction of the rate change. If the interest rate goes up, consumers generally spend less and save more, whereas if the interest rate goes down, they tend to spend a little more and save less. Interest rate risk can affect any market, including shares, commodities and bonds.
For example, if the Federal Reserve (Fed) Funds rate goes up, a US company may want to borrow less money from the banks, reducing its spending and investment. At the same time, the higher interest rate may attract more foreign capital to the US, causing the dollar to appreciate in value. This, in turn, would likely make the company’s exports less competitive internationally. Both effects could therefore negatively impact the company’s growth, profits and share price.
Equity price risk
Stock prices can be very volatile, more so than some other asset classes. The price of a security can change very quickly, often causing it to dip in value. This is known as equity price risk. While there are several factors that affect share prices, there are only two types of equity risk, namely systematic and unsystematic risk. The first is the risk related to the general industry, while unsystematic risk pertains to a certain company.
For example, you buy 500 ABC stocks for $20 per stock with the aim of selling the shares at a higher price. But then, the unexpected resignation of the CEO causes the share price to drop to $14. If you sell the shares then, you will make a $7000 loss. That is the equity price risk you must carry.
Exchange rate risk
Exchange rate risk, also known as currency risk or foreign exchange risk, is the risk associated with the fluctuation of currency prices. When currency prices change, it becomes less or more expensive to buy foreign assets, depending on the direction of the change. Exchange rate risk increases if the trader is exposed to international forex markets, though a trader can be exposed indirectly by owning shares in a company that does a lot of foreign trade, or by trading commodities priced in foreign currency. Further, a country with higher debt will have a high currency risk.
For example, assume the Brazilian real is trading at R$5 against the British pound. A British retailer enters into a business deal with a Brazilian coffee producer to buy 10,000 packets of roasted coffee at R$20 per packet – a total deal worth R$200,000 (£40,000). Before the British company receives the goods, a sudden political crisis causes the GBP to weaken, making it trade for R$4. The retailer would still have to pay the agreed amount per packet (R$20), which means the deal is now equal to £50,000.
Commodity price risk
Commodities, such as crude oil, gold and corn, can experience sudden price fluctuations if there are any sort of political, regulatory or seasonal changes. This risk is known as commodity price risk. Commodity price changes can affect traders, investors, consumers and producers.
For example, a drought can affect corn production and could therefore cause a price increase. If you have a position on corn, you are exposed to this commodity price risk.
However, commodity price risk extends beyond the risk of price changes to the commodities themselves. They are the building blocks of most goods, which is why changes to their prices can have far-reaching consequences for companies and consumers. Price changes put strain on the entire supply chain, which ultimately affects economic performance.
How to measure market risk
There are two main methods used to measure market risk: value-at-risk (VaR) and Beta:
- Value-at-risk is a statistical method, applied over a specific time frame, that can measure the extent of the risk (potential loss), as well as the likelihood that the loss will occur (occurrence ratio)
- Beta measures the volatility of stock, based on its previous performance, compared to the market as a whole. In other words, it determines if stocks move in the same direction as the market
However, there is no agreed-upon method for measuring market risk with either of these methods – some can be very simple, while others are quite complicated.
How to hedge market risk
Hedging is defined as holding two or more positions at the same time with the intent of offsetting any losses from one position with gains from another. Hedging market risk is one way to manage your trading risk. Many traders appreciate that certain risks are necessary – and could give them the long-term returns that they’re looking for – but hedging offers some risk protection while giving traders the exposure they want.
Your hedging strategy will depend on the market you’re trading.
An option is a financial instrument that offers the holder the right, but not the obligation, to buy or sell an asset at a set price within a set time period. Options trading gives you the opportunity to hedge against your positions through delta hedging and risk reversal.
If you’re trading the stock market, delta hedging can help you to reduce the risk of negative price movements in the underlying market. ‘Delta’ is the amount an option’s price will move when its underlying asset changes one point in price.
An options position can be hedged with another options position that has an opposing delta. For example, if a put option on a stock has a delta of -0.10, it will rise by $0.10 if the share price falls by $1. This can be hedged with a call option that has a delta of +0.10, that will rise by $0.10 if the share price increases by $1.
Or, you can create a delta hedge by opening a position using derivatives, such as CFDs. These derivatives will have a delta of one, because the derivative moves one to one with the underlying market. For example, if you are long one call option for 100 shares with a delta of 0.55, you could hedge this delta exposure by shorting 55 shares of the stock via a CFD trade.
Risk reversal can protect a traders’ long or short positions through put and call options. For example, if you’re a commodities trader and you open a short position on 200 units of soybeans, you can hedge it by buying a put and call option, both for 200 units of soybeans. If the price of soybeans rises, the call option will become more valuable and offset any losses to the short position. If the price of soybeans fell instead, you would profit from the short position but only to the strike price of the put option.
Futures are contracts to trade a financial market at a defined price on a fixed date in the future. With futures contracts, you can hedge against your positions on commodities, stocks, bonds and more. Futures contracts eliminate the uncertainty about the future price of a security because they enable you to lock in a price at which you want to buy or sell in the future. That way, you can offset your price movement risk.
Market risk summed up
We’ve summarised a few key points to remember on market risk below.
- Market risk affects the entire market – it can’t be avoided through portfolio diversification
- There are four main types of market risk, namely interest rate risk, equity price risk, exchange rate risk and commodity price risk
- There are several methods you can use to measure market risk, including value-at-risk and Beta
- You can hedge against market risk via options trading or with futures contracts