One of the major aims of many financial institutions is the generation of profits through investment in global financial markets. This business, by its nature, is based on price uncertainty – the uncertainty of knowing whether market prices will move in a favourable or adverse direction.
Price uncertainty is the mechanism that allows profits or losses to be made, and the risk of loss associated with it is known as market risk. This risk reflects the uncertainty of an asset’s future price. The factors affecting market risk are complex. For instance, there are direct and indirect market risk factors to consider. when investing in a company’s shares
Direct market risk factors directly reflect a company’s performance, such as the health of its balance sheet, its vision, and the strength of its management team. Indirect factors indirectly affect a company’s performance, such as interest rate levels, economic events, political, sector sentiment, and environmental effects.
The financial services sector takes advantage of market risk to make a profit. Managing this risk is not to eradicate it but to understand and quantify it. If this is done accurately, an informed decision can be made on how acceptable the risk is and, hence, whether it is a worthwhile investment. As there are vast profits to be made in getting this right, financial institutions have invested heavily in research, tools, and expertise to predict the future performance of their investments.
Understanding this market risk is also essential in pricing financial products, such as futures and options. For these reasons, the methods and tools used for measuring market risk have become very advanced, involving cutting-edge mathematical theory and computer processing technology. This article provides a basic understanding of these methods and tools and explains how they fit into an overall risk management strategy.
Market risk can be defined as: ‘The risk of loss arising from changes in the value of financial instruments’.
Market risk can be sub-divided into the following types:
1 Volatility Risk
Volatility risk is the risk of price movements that are more uncertain than usual, affecting the pricing of products. All priced instruments suffer from this form of volatility. This mainly affects options pricing because if the market is volatile, then the pricing of an option is more complicated, and options will become more expensive.
2 Market Liquidity Risk
In market risk, this is the risk of loss through not being able to trade in a market or obtain a price on the desired product when required. Market liquidity risk can occur in a market due to either a lack of supply or demand or a shortage of market makers.
3 Currency Risk
Adverse movements in exchange rates cause this. It affects any portfolio or instrument with cash flows denominated in a currency other than the firm’s base currency. Currency risk is also inherent when trading cryptocurrencies. These are digital currencies in which encryption techniques regulate the generation of currency units and verify the transfer of funds, operating independently of a central bank. Cryptocurrencies often display far higher volatility than so-called fiat currencies.
4 Basis Risk
This occurs when one risk exposure is hedged with an offsetting exposure in another instrument that behaves similarly, but not identical, manner. If the two positions were truly ‘equal and opposite’, then there would be no risk in the combined position. Basis risk exists so that the two positions do not precisely mirror each other.
5 Interest Rate Risk
This is caused by adverse movements in interest rates and will directly affect fixed income securities, futures, options and forwards. It may also indirectly affect other instruments.
6 Commodity Price Risk
This is the risk of an adverse price movement in the value of a commodity. The price risk of commodities differs considerably from other market risk drivers because most commodities are traded in markets where the concentration of supply in the hands of a few suppliers can magnify price volatility.
Fluctuations in the depth of trading in the market (i.e., market liquidity) often accompany and exacerbate high levels of price volatility. Other fundamentals affecting a commodity’s price include the ease and cost of storage, which varies considerably across the commodity markets (eg, from gold to electricity, to wheat). As a result of these factors, commodity prices generally have higher volatilities and more significant price discontinuities (i.e., moments when prices leap from one level to another) than most traded financial securities.
7 Equity Price Risk
The returns from investing in equities come from:
- capital growth – if a company does well, the price of its shares should go up
- income – through the distribution by the company of its profits as dividends.
- the capital – the share price may fall or fail to rise in line with inflation or with the performance of other, less risky investments
- the income – if the company is not as profitable as hoped, its dividends may not keep pace with inflation; indeed, they may fall or even not be paid. Unlike bond coupons, dividend payments are not compulsory
- liquidity risk could be caused by a lack of supply or demand – which also causes price level risk
- an increase in volatility risk will exacerbate price level risk for investors wishing to buy or sell
- interest rate risk will indirectly affect the real economy and the markets.
- risk limits usually have to be inflated to accommodate the errors and uncertainty in the measurement. This adversely affects the potential profit of the firm.
- traders or other investment professionals may exploit the inaccuracy of risk measurement and take risks that they know the measurement does not account for.
- Check out our track on: Risk: Management, Data and Ethics
- Check out our course on: Risk: Trading Products and Currencies
Evita Veigas
7 min read