What is market risk?
Looking for a market risk definition? The place to start is the name itself. Market risk is a type of risk associated with the market as a whole rather than with individual stocks or business sectors. In other words, it is the risk that the market overall will lose value, rather than that one or more stocks or sector will go out of favour to be replaced by those upon whom investors are smiling.
Where have you heard about market risk?
As an investor, you will be alert to market risk even if you don’t yet use the market risk definition. Panics and crashes on Wall Street and elsewhere are part of market lore. Everyone has heard of tulip-mania, the Wall Street Crash and Black Monday. Your financial adviser will be on the lookout for signs of a bubble likely to burst, and financial media will scan the horizon for common causes of market risk including interest-rate risk, equity-price risk, commodity risk and foreign exchange risk.
What you need to know about market risk…
Market risk is also known as systematic risk and undiversifiable risk. The word ‘systematic’ refers to the way such risk affects the whole market, systematically threatening share prices. Such a risk is undiversifiable because, by definition, it is impossible to seek safety in a diversified portfolio when every element of that portfolio is facing the same risk.
It is, however, possible to hedge against market risk, of which more in a moment.
Common types of market risk
Interest-rate risk is one of the most common sources of danger for investors, for two main reasons. Credit helps to fuel share purchases, especially when people are trading on margin with their broker. Once this credit becomes more expensive, because of a rise in interest rates, not only will demand for shares start to sag, but some investors will liquidate their positions in order to pay what they owe.
This, in turn, puts pressure on share prices.
The other way in which interest-rate risk affects markets is that cash becomes a more attractive investment relative to shares, thus taking investors away from stocks.
Equity-price risk describes the phenomenon – sometimes known as a bubble - whereby valuations have become so stretched that few can afford them. This is sometimes described as the working out of the ‘greater fool theory’, in which those who bought during a boom did so on the basis that someone else – a greater fool – would pay more for what were already clearly-overpriced shares. Once the prices are so high that no-one can afford them, there is no-one to whom to sell them, other than at a discount.
As is the way with equity-price risk, those discounts deepen rapidly, and before long a full-scale crash can develop.
Commodity risk arises when the market is destabilised by a sharp and unexpected movement – usually, but not necessarily, upwards – in the price of a commodity vital to the functioning of the national or global economy. Oil is an obvious example, while others would include base metals such as iron ore, foodstuffs such as corn and wheat and animal feed.
Typically, commodity risk is triggered by an event such as war, drought, political instability or other unanticipated happening. In grappling with commodity risk, governments may decide to release any emergency supplies of the item in question that they hold – such as the US Strategic Petroleum Reserve – and this may help to calm markets.
Foreign exchange risk has connections to all these previous types of risk. Exchange rates are strongly influenced by interest rates, and a movement up or down in the value of the currency can both make foreign-exchange speculation a more profitable activity than share investment, diverting cash from stocks, and make the equity market more or less attractive to foreign buyers, depending on whether the currency has gone up (thus making shares more expensive) or down (making them cheaper).
Falling down together
In reality, the four types of risk are as likely to join forces to destabilise markets as they are to make solo appearances. Take the UK stock-market crash of 1973-1974, on some measures the worst the country has ever experienced.
Was that an interest-rate event? In part, yes – rates were raised to try to choke off inflation. Were equity prices a trigger? Again, in part. Valuations peaked in 1972 and did not return to that level, after inflation is taken into account, until 1986.
Did the exchange rate play a part? Again, yes. The pound had been floated on currency markets in 1972 and came under almost constant pressure.
As for commodity risk, that goes without saying – the energy crisis of October 1973 with quadrupling of oil prices was the biggest single factor in the market collapse.
Hedging market risk
Market risk cannot be mitigated by diversification, but it is possible to try to ‘hedge it out’.
Suppose an investor believes Retailer A will outperform Retailer B. In those circumstances, they would take a long position in the first company and a short position in the second. Market risk means that both sets of shares will fall, but that those of the first company will fall by less than those of the second company.
By shorting those of the second company, the trader has pocketed the original, higher price from the sale of the second company’s shares and is holding the stock that has performed the better out of the two.
A less elaborate way to reduce the damage that can be caused by market risk is to buy those securities such as mature, household-name companies and utilities, whose prices move relatively slowly, both up and down.
Value at risk and unsystematic risk
Institutions use a value-at-risk (VAR) model to calculate the potential for loss on one or more portfolios under a series of circumstances and the likelihood of those circumstances occurring. This can help prepare against market risk but, by definition, the more extreme expressions of market, or systematic, risk are difficult to predict.
In 2012, the global consulting group McKinsey, while praising the work undertaken in this field, said: “VAR and other risk models have continually come up short,”, citing the 1998 crisis at Long Term Capital Management, a US hedge fund, and the 2007-2008 financial crisis.
Unsystematic risk, by contrast, affects not the whole market but only parts of it. That means that it is possible to protect against even unanticipated events by diversifying across different sectors and companies. This type of risk is far more common, because by definition there will be a constant ‘churn’ in firms and sectors experiencing difficulties and going in and out of favour with markets.
Find out more about market risk…
The European Banking Authority has this to say: “From a regulatory perspective, market risk stems from all the positions included in banks' trading book as well as from commodity and foreign exchange risk positions in the whole balance sheet.” Find out more here.