What is market Risk in investment Banking?
Market risk is the possibility for an investor to experience losses due to factors that affect the overall performance of the financial markets in which he is involved. Market risk, also called "systematic risk, " cannot be eliminated through diversification, though it can be hedged against. Sources of market risk include recessions, political turmoil, changes in interest rates, natural disasters and terrorist attacks.
BREAKING DOWN 'Market Risk'Companies in the United States are required by the SEC to detail how their productivity and results may be linked to the performance of the financial markets. This is meant to provide a reflection of how a company is exposed to financial risk. For example, a company providing derivative investments or foreign exchange futures may be more exposed to financial risk than companies who do not provide these types of investments. This information helps investors and traders make decisions based on their own risk management rules.
The two major categories of investment risk are market risk and specific risk. Specific risk, also called "unsystematic risk, " is tied directly to the performance of a particular security and can be protected against through investment diversification. One example of unsystematic risk is a company declaring bankruptcy, making its stock worthless to investors.
Under these categories are different classifications that involve unique aspects of financial markets. The most common types of market risks include interest rate risk, equity risk, currency risk and commodity risk.
Interest rate risk covers the volatility that happens with changing interest rates due to fundamental factors, such as Libor and other central bank announcements related to changes in monetary policies. Equity risk is the risk involved in the changing stock prices. An investor is exposed to currency risk if he is holding particular currencies facing volatile movements, because of fundamental factors such as interest rate changes or unemployment claims. Commodity risk covers the changing prices of commodities such as crude oil and corn.
Market Risk Due to Volatility
Market risk exists because of price changes. The standard deviation of changes in prices of stocks, currencies or commodities is referred to as price volatility. Volatility is rated in annualized terms. It may be expressed as an absolute number, such as $10, or a percentage of the initial value, such as 10%.
Value at Risk
To measure market risk, investors and analysts use the value at risk method. The value at risk method is a well known and established risk management method, but it comes with some assumptions that limit its correctness. For example, it assumes that the makeup and content of the portfolio being measured is unchanged over a provided period. Though this may be acceptable for short-term horizons, it may provide less accurate measurements for long-term horizons of investments, because it is more exposed to changes in interest rates and monetary policies.