Whenever you take an initiative, there have to be risks involved; they’re everywhere. So it’s no surprise that all kinds of markets have the risks, or possibilities of failing. Market risk is basically the possibility that the value of any investment will decrease, mostly because of changes in the market factors. Such factors might have an impact on the whole financial market as well. These risks are also called ‘systematic risk’ sometimes. Mostly because they relate to the factors like recession, impacting the whole impact in the process.
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Market risks also sometimes refer to the problems that any investment may face when fluctuations occur in the market. The problem with this is, the investment’s value will decrease if such risk occurs. The risk usually contrasts with specific risks, more commonly known as unsystematic risks. Market risks usually cover the overall economy or other markets, but the unsystematic risk is just a part of it.
If we are to go for the major types of risks, there are four.
- Interest Rate Risk
- Equity Price Risk
- Foreign Exchange Risk
- Commodity Price Risk
Interest Rate Risk
This risk states that the value of a security will fall if the interest rate is increased. There can be more complex scenarios, but for now, let’s assume the simpler one. Interest Rate Risks can be divided into a few more sub-parts.
- Basis risk
Let’s say, the liabilities and the interest-bearing assets do not have the same base. They have different bases. Since the bases aren’t the same, in different circumstances different bases would move in different directions or different rates, which means there will be mass changes in revenues and expenses.
- Repricing risk
If reprice happens at different times and rates, that might cause serious risks. Assets and liabilities play a game here as they can reprice. A loan with a flexible price is more advantageous to a bank but if the rates keep fluctuating that might cause a risk.
- Yield curve risk
The differences between short-term and long-term interest rates are what causes this yield curve risk. Usually, the short-term rates are lower considering the long-term assets, but if there is any change in that, then it could dramatically affect earning.
- Options risk
Sometimes there are some options embedded in some assets or liabilities. These rises the options risk. In a changing interest rate, mortgage loans can be a good example of this if interest rate changes. This risk is very difficult to control.
Equity Price Risk
When the stock prices are volatile, the risks of price equity arises. Say, if the stock prices are very unpredictable, then the price equity may not be able to be maintained. This risk is known as the equity price risk.
Foreign Exchange Risk
This risk is related to changes in exchange rates. A very common problem in the modern world, currency rate change can be pretty damaging to companies and private farms.
If the value of money in a specific country remains constant or non-volatile, then the exchange rates usually don’t fluctuate. But when they do, they contain foreign exchange risks.
Commodity Price Risk
This is one of the most common risks there is. Price hikes or downfalls usually cause these. Commodity price risks usually mean an unexpected change in a particular commodity price. For example, if the price of potatoes increases then this will create a risk, known as the commodity price risk.
Commodities can be grains, gas, electricity, food, etc. They affect different sections of people from different communities. Here is a small list of people who actually get affected by this risk.
- Producers (Farmers, fishermen, food industries)
- Buyers (Commercial traders, buying companies, etc.)
- Exporters (The ones who exports it abroad)
- Government (The all-seeing overseer)
Apart from these major types of risks, there are some risks that are worth mentioning. They might not be as frequent as the major ones, but they do possess serious threats at times.
This is based on the potentials of inflation that can initially increase the prices of all kinds of goods and services. In this process, inflation undermines the money value, allowing the price level to go higher.
When inflation occurs, all on a sudden exchange rate go higher, everything turns out to be costlier than ever, and the companies face various troubles to cope up with the sudden price-hike. In a sense, when inflation occurs, most other risks come to the misery of the companies, so it is a catastrophic disaster for them.
Hedging: A Process To Mitigate Market Risk
Risks are bags and baggage of any initiatives someone takes. As such, market risks cannot really be removed or mitigated, at least not by diversifying it. But we sure can try to hedge the risks out. But what exactly is this hedging?
Suppose, there are two companies, A and D. An investor, Mr. X believes A will surpass D very soon, so he will invest more on the stocks of A and less on the stocks on D. Now market risks states that both companies will initially fall, but it is more likely that the fall on A’s stock prices will be less than that of D’s. In this process, he is hedging out the maximum utility through both the companies.
Another way to reduce damage is to buy more secured shares and assets so that when something like a market failure occurs, they don’t face a lot of losses. For example, household-name companies and utilities have relatively rigid price levels, they don’t fluctuate much. So even if a market fails, the prices seldom fall down.
To conclude, there are several types and kinds of market risks; each one of them can be a reason for a mass-market failure. But in reality, they are quite interconnected. Take the UK stock-market crash of 1973-1974 for an example. It all started off with what people may say interest rate-event. But it soon turned the exchange rate upside down, causing issues in the commodity rate as well! So the risks are all interrelated and can be the reason for a market failure anytime, anywhere.