Market risk, also known as systematic risk, is the risk of losses in financial investments due to overall market movements. Unlike credit or operational risk, it cannot be eliminated by diversification because it affects the entire market.
🔹 Main Types of Market Risk:
- Equity Risk – The risk of loss due to falling stock prices.
Example: A market crash reduces your equity portfolio value. - Interest Rate Risk – Changes in interest rates affect bond prices and loan costs.
Example: Rising interest rates lower bond values. - Currency (Foreign Exchange) Risk – Arises from investing or transacting in foreign currencies.
Example: A U.S. investor in Indian stocks may lose money if the rupee weakens. - Commodity Risk – The risk of price swings in raw materials like oil, gold, or wheat.
Example: A spike in oil prices impacts airline company profits.
🔹 Who is Affected by Market Risk?
- Retail Investors
- Individuals investing in stocks, mutual funds, ETFs, or bonds.
- Market downturns can significantly impact personal wealth.
- Institutional Investors
- Pension funds, hedge funds, insurance companies that manage large portfolios.
- Even small market shifts can affect returns at scale.
- Banks & Financial Institutions
- Engage in trading, lending, and investment activities that are exposed to interest rates, forex, and asset prices.
- Volatility impacts balance sheets and regulatory capital.
- Corporates
- Companies with global operations face currency and commodity risks.
- Example: An IT company earning in USD but paying in INR.
🔹 How is Market Risk Managed?
- Diversification
- Spreading investments across sectors, regions, and asset classes to reduce exposure to any single risk.
- Hedging with Derivatives
- Using futures, options, and swaps to lock in prices or protect against adverse moves in interest rates or currencies.
- Value-at-Risk (VaR) Analysis
- Quantifies potential loss in portfolio value over a specific time period and confidence level.
- Stress Testing & Scenario Analysis
- Simulating extreme market conditions (like a crash or rate spike) to assess impact on portfolios.
- Strategic Asset Allocation
- Aligning asset mix with risk tolerance and investment horizon, and rebalancing periodically.
Key Takeaways
- Market risk refers to potential losses due to fluctuations in market variables like stock prices, interest rates, currencies, or commodities.
- It is a systematic risk, meaning it affects all participants and cannot be fully avoided through diversification.
- Types include equity risk, interest rate risk, currency risk, and commodity risk.
- It impacts investors, banks, and companies exposed to financial markets or global operations.
- Managed through diversification, hedging, and risk assessment tools like VaR and stress testing.
