Market risk is the potential loss incurred by financial instruments from movements in prices and rates. It’s considered undiversifiable risk and is difficult to mitigate.
There are four types of market risk: Commodity risk, Liquidity risk, Interest rate risk and Counterparty risk. Let’s take a closer look at each of these.
A company’s commodity risk is the threat of price fluctuations in raw materials. It affects both commodity producers and companies that rely on them. For example, if the price of oil drops, a company that invests heavily in oil drilling will see its profit margin shrink. However, if it diversifies its supply chain and uses alternative energy sources for some of its production, it can reduce this type of risk.
In addition to commodity risk, businesses must also consider liquidity risk. This occurs when an investment isn’t able to be bought or sold quickly for a reasonable price. Some markets have a higher liquidity risk than others, such as foreign investments and small-cap stocks. The business can minimize this risk by using futures contracts, which allow investors to buy or sell a security at a set price in the future. It can also diversify its supply of raw materials by purchasing from multiple suppliers.
Liquidity risk is the danger that a company may not be able to fulfill its short-term commitments. This can happen when a business has illiquid assets that can take months or years to turn into money. Examples of illiquid assets include real estate and bonds. Companies can measure their liquidity risk by using different methods, including the acid test or quick ratio. The acid test measures current assets (such as accounts receivable) minus current liabilities, while the quick ratio uses only current assets and excludes inventory.
Market liquidity risk is the difficulty of selling an investment quickly for a price that reflects its true value. It can be caused by a lack of buyers, or by inefficient market microstructures. Foreign investments, over-the-counter markets and small-cap stocks are generally more vulnerable to liquidity risks.
Other types of market risk include equity-price risk, interest rate risk and commodity risk. These risks can be mitigated by minimizing the duration of an investment and diversifying investments across asset classes.
Interest rate risk
Interest rate risk is the chance that an investment will lose value because of a change in interest rates. This type of market risk is most relevant to fixed-income investments, such as bonds, but it can also affect currencies and share indices. Interest rate changes often impact the view of a country’s economy and can cause price volatility.
Interest rates are typically influenced by central bank announcements regarding their monetary policy. The sensitivity of a bond’s price to a change in interest rates depends on its duration. Longer-term bonds are more sensitive to changes in interest rates than short-term bonds.
For businesses, this kind of market risk is a key concern when offering credit to customers and suppliers. It’s important to understand the potential impacts of interest rate changes and how to hedge them effectively.
Counterparty risk is the possibility that a business or individual will default on its contractual obligations. It can be influenced by factors that are specific to the business itself, such as financial performance and market trends. It can also be influenced by factors that are beyond the control of the business, such as broader economic conditions.
This type of risk is especially significant in derivatives markets, where notional values can exceed underlying securities. This is why central counterparties, or CCPs, are used to protect traders from potential losses by requiring collateral from each party in the transaction. This helps reduce both operational and market risk by preventing mark-to-market volatility in hedging instruments.
Market risk is the chance that prices will move in a way that decreases the value of an investment, such as a stock or a bond. It can be reduced through stop-loss orders, which limit loss to a certain amount. It is also possible to limit this risk by investing in assets that are rated highly, such as corporate bonds.