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Market Risk Definition How to Deal with Systematic Risk

Market Risk Definition How to Deal with Systematic Risk

Market Risk Definition: Dealing with Systematic Risk

Market risk is the possibility of individuals or entities experiencing losses due to factors that affect the overall performance of financial market investments.

Key Takeaways:

– Market risk, or systematic risk, affects the entire market simultaneously.

– Market risk cannot be eliminated through diversification.

– Specific risk, or unsystematic risk, involves the performance of a particular security and can be mitigated through diversification.

– Market risk may arise from changes in interest rates, exchange rates, geopolitical events, or recessions.

Understanding Market Risk:

Market risk and specific risk make up the two major categories of investment risk. Market risk, also called systematic risk, cannot be eliminated through diversification, though it can be hedged in other ways. Sources of market risk include recessions, political turmoil, changes in interest rates, natural disasters, and terrorist attacks. Systematic risk tends to influence the entire market simultaneously.

This can be contrasted with unsystematic risk, which is unique to a specific company or industry. Also known as nonsystematic risk, specific risk, diversifiable risk, or residual risk, unsystematic risk can be reduced through diversification.

Market risk exists because of price changes. The standard deviation of changes in stock, currency, or commodity prices is referred to as price volatility. Volatility is rated in annualized terms and may be expressed as an absolute number, such as $10, or a percentage of the initial value, such as 10%.

Publicly traded companies in the United States are required by the Securities and Exchange Commission (SEC) to disclose their exposure to financial risk and how it may impact productivity and results. This information helps investors and traders make decisions based on their own risk management rules.

Other Types of Risk:

In contrast to market risk, unsystematic risk or specific risk is directly tied to the performance of a specific security and can be protected against through investment diversification. Examples of unsystematic risk include a company declaring bankruptcy, which makes its stock worthless to investors.

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The most common types of market risks are:

– Interest rate risk: Volatility accompanying interest rate fluctuations, primarily affecting fixed-income securities such as bonds.

– Equity risk: Risk involved in changing stock prices.

– Commodity risk: Changing prices of commodities like crude oil and corn.

– Currency risk: Change in one currency’s price relative to another, affecting investors or firms holding assets in another country.

Managing Market Risk:

There is no single way to completely avoid market risk when investing, but hedging strategies can be used to protect against volatility and minimize its impact on investments and overall financial health. For example, buying put options can protect against downside moves when targeting specific securities. Utilizing index options can hedge a large portfolio of stocks.

Various strategies can be used to manage market risk and protect portfolios. Dollar-cost averaging won’t protect against market risk, but investing the same amount regularly can help ride out market ups and downs, taking advantage of low costs and high returns.

Study Currency Profiles:

When investing in foreign markets, pay attention to the currency profiles of the companies in which you invest. Industries that import more are impacted by changes in the local currency, while those that export more are affected by changes in the value of the euro or the dollar. Mitigate risk by allocating assets across a variety of industries and investing in markets and companies backed by strong currencies.

Watch Interest Rates:

To manage interest rate risk, pay attention to monetary policy and be prepared to adjust investments to account for interest rate changes. For instance, focus on shorter-term bonds when heavily invested in bonds and interest rates are rising.

Maintain Liquidity:

During volatile markets, liquidity may be a challenge when selling or buying assets within a desired price range, especially when exiting positions quickly. Stick with stocks that have low impact cost to maintain liquidity and make trading easier under normal conditions.

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Invest in Staples:

Some industries tend to do well even in a poor overall economy. Utilities and businesses producing consumer staples are examples because people still need essential goods regardless of economic conditions. Investing in staples allows for returns during recessions or periods of high unemployment.

Think Long Term:

Market risk and volatility cannot be fully escaped, but they can be managed by adopting a long-term investing strategy. Making small adjustments in response to market changes is wise, but avoid completely upending the investment strategy due to a recession or currency fluctuation.

Short-term traders are more vulnerable to volatility, but over time, volatility tends to even out. Systematic investing, sticking with a long-term outlook and strategy, increases the likelihood of portfolio recovery from market risks.

Measuring Market Risk:

The value-at-risk (VaR) method is commonly used to measure market risk. VaR modeling quantifies a stock’s or portfolio’s potential loss and the probability of that loss occurring. However, the VaR method has limitations due to certain assumptions, limiting its precision.

Another relevant risk metric is beta, which measures the relative volatility or market risk of a security or portfolio compared to the overall market. Beta is used in the capital asset pricing model (CAPM) to calculate an asset’s expected return.

What’s the difference between market risk and specific risk?

Market risk and specific risk are the two major categories of investment risk.

Market risk, or systematic risk, cannot be eliminated through diversification, though it can be hedged in other ways. It influences the entire market simultaneously.

Specific risk, in contrast, is unique to a particular company or industry. It can be reduced through diversification and is also known as unsystematic risk, diversifiable risk, or residual risk.

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What are some types of market risk?

The most common types of market risk include interest rate risk, equity risk, commodity risk, and currency risk.

Interest rate risk is associated with interest rate fluctuations, especially in fixed-income investments such as bonds.

Equity risk involves changing stock prices.

Commodity risk is related to changing prices of commodities like crude oil and corn.

Currency risk, or exchange-rate risk, arises from changes in currency prices, affecting investors holding assets in another country.

How is market risk measured?

The value-at-risk (VaR) method is widely used to measure market risk. It quantifies potential losses and the probability of their occurrence. Beta, another relevant risk metric, measures the relative sensitivity of an asset to market movements.

Is inflation a market risk?

Inflation can contribute to market risk by impacting business performance, consumer behavior, and investor confidence. It may result in monetary policy adjustments, such as increased interest rates, potentially leading to a recession and overall market slowdown.

Inflationary risk refers to the rising prices caused by inflation potentially outpacing investment returns. It isn’t a specific type of market risk but a type of investing risk. Minimizing inflationary risk can be achieved through diversification, early investing to benefit from compound interest, and more aggressive investing at a younger age.

The Bottom Line:

Market risk refers to the possibility of incurring losses from factors that affect the overall performance of financial markets, such as changes in interest rates, geopolitical events, or recessions. It is systematic risk and cannot be eliminated through diversification. On the other hand, specific risk is unique to individual stocks or industry sectors and can be minimized through diversification.

Methods such as the value-at-risk (VaR) method, risk premia, and beta coefficient can be used to measure market risk. It is important to understand and manage market risk while investing to protect portfolios and achieve financial goals.

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