MARKET RISK

MARKET RISK

Market risk is the risk that we face due to the decrease in the market price of a financial product which arises out of the factors that affect the market as a whole and is not limited to a particular commodity. Often called systematic risk, the market risk exists because of uncertainties in the economy, natural or man made disasters, political environment or recession. It can not be eliminated but can only be hedged by diversification. 

TYPES OF MARKET RISK 

Majorly, there are 4 types of market risks:

1. Forex risk:

Forex risk rises because of the fluctuations in the exchange rate between the foreign and domestic currency. The most affected by this risk is the MNCs that operate across countries or geographic areas and have their payments made in different currencies. 

2. Equity price risk:

The next component is equity price risk which refers to the change in the price of the stock. As equity is most volatile and sensitive to any change in the economy, equity price risk is one of the most significant parts!

3. Interest rate risk:

Interest rate risk results when the value of the stocks might fall because of the decrease or increase in the prevailing and long term interest rate. It is a broader term and comprises various components like yield curve risk, basis risk, repricing risk and option risk. 

4. Commodity price risk:

Like forex risk, commodity price risk exists because of fluctuation in commodities like gold, crude, silver etc. Nevertheless, unlike forex risk, commodity risk affects not only the MNCs but also ordinary people like small business, farmers, exporters, commercial traders and governments. 

MARKET RISK PREMIUM FORMULA 

One factor used to calculate the market risk is the market risk premium calculation. Put market risk premium is the difference between the expected return rate and the prevailing risk free rate of return.

Mathematically, the formula for market risk premium formula is as follows:

Market risk premium = expected return - risk free rate.

The risk premium has 2 important aspects required, market risk premium and historical premium. It is based on the expectations that the investor community has from the near future or pattern of prior period. 

MERITS 

• The market risk premium helps an investor to compute the real rate of returns. Even though the financial alternative might enjoy presenting a lucrative return, the investor should gauge the investment in light of the actual rate it provides. This can be computed by taking into account the prevailing inflation rate and risk free interest rate. 
• Most often than not, financial alternatives are sold to the investors by aggressive marketing and by presenting only the growth part while ignoring the downfalls and risks. This is why we see such products being bought more in the economic expansion cycles while being in the recession, investors are trapped especially the retail ones. Had the investor known about the market risk and its computation, they can understand the financial alternative in a much more efficient way and make a decision if it suits them for such vulnerability and volatilities. 

DISADVANTAGE 

• It is very prone to cyclic or recession changes in the economy. And since it affects the complete market parallely, it is even more challenging to manage as diversification will not assist. Unlike credit risk, which is very much specific, it affects all asset classes. 
• We can’t ignore them completely. It can only be hedged which comes with intensive and cost calculations. An investor must be appropriate to understand what data they need to analyse and what data needs to be filtered out.