What is Market Risk? - How its Measured and its Sources
The global financial system is connected to markets. Markets are where companies go to if they want to raise funds. They are also the place where current investors go when they want to liquidate their existing investments. Hence, it would be fair to say that the financial system of the entire world is closely intertwined with the global market system.
Now, the fundamental principle of an efficient marketplace is that firms are not price makers. Instead, they are price takers. This means that they have very little control over the prices in the market. The absence of control obviously means that there is a risk attached to it. This risk is called market risk. In this article, we will discuss the concept of market risk in detail.
What is Market Risk?
Market risk is the risk that a change in the market value of an asset or liability held by the firm will lead to financial losses to the firm. This includes the value of the assets and liabilities held on the balance sheet as well as those which are held off the balance sheet.
Market risk is the risk of a negative change in the net worth of a company due to changes in external markets such as stock markets, bond markets, and currency markets. Understanding and mitigating market risk, in a timely manner, is extremely important. The inability to do so has led to the bankruptcy of several firms which were caught off guard during the dot-com crisis, Enron crisis, or even the subprime mortgage crisis.
How is Market Risk Measured?
Measuring market risk is a fairly complicated process. We will explain it in detail in the later parts of this module. However, for now, it is important to understand that market risk is a function of market volatility.
Volatility is defined as the degree of change in the value of an asset on a day-to-day basis. This is the reason why equity investments are said to have more risks as compared to debt investments since their value tends to fluctuate more.
Measures such as standard deviation are used to understand the dispersion in the data. This is because volatility is calculated by finding a mean price and then observing the spread of the distribution of the data. Hence, the standard deviation is considered to be a valid measure are to estimate market risk. The more sophisticated way to measure market risk is by using a technique called Value At Risk (VaR) which will be explained later in this module.
Sources of Market Risk
For a market risk to arise, the company has to be somehow connected to that market either in a direct or an indirect manner. Since equity, commodity, forex, and interbank markets are some of the largest markets in the world, they are also major contributors to market risk.
- Equity Risk: Prices of equities keep changing on a day-to-day basis. Based on market sentiments, equity markets scale to new heights or reach depressing lows. These changes are often temporary and in the long run, equity prices tend to correct. However, in the short run, they could lead to severe financial losses for the company.
- Commodity Risk: Commodities like gold, silver, steel, aluminum, and even foodgrains are extensively used in the production of many goods and services. As a result, a change in the value of these goods and services causes a change in the input price which can cause a huge negative financial impact on the financials of a company. Therefore, some companies are closely linked to the market and seemingly small changes in the market have a huge impact on them.
- Interest Rate Risk: Interest rate risks are the financial losses that accrue as a result of the change in interest rate in the interbank market. This is because the interbank interest rates, as well as the interest rates of government securities, are the basis on which all interest rates are issued. It is possible for firms to face duration mismatch or interest rate mismatch. Such issues can be significant and can even lead to bankruptcy if the firm is making leveraged bets. Also, the coupon payments of many bonds are linked with the benchmark interest rates. This too causes
- Currency Risk: A lot of companies sell their products internationally. As a result, they have exposure to some amount of foreign exchange risks. Also, many companies raise capital from other markets because the cost of capital is lower. Here too, currency risks are involved. In such cases, the change in the value of one currency relative to the other will cause immense financial loss to some companies.
The fact of the matter is that companies in the modern world have to be linked to the financial markets. Hence, it is impossible to avoid market risks. Therefore, the creation and management of a system to measure and mitigate market risk are of utmost importance to the financial well-being of any corporation.
The market risk management system has to be suitable for the nature and scale of the organization. In many cases, the organization may not be directly exposed to these risks. However, some of their stakeholders might be exposed to them which would change their actions and would therefore impact the organization in an indirect manner.
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