Business owners who wants to gain an advantage in an industry advantage must be familiar with market risk and risk mitigation. MyBusiness discusses the basics of market risk and what business owners can do to prevent it.
What is market risk?
Simply put, market risk or systematic risk is the possibility of a specific business incurring losses due to factors affecting the market or the industry that the business belongs to. Some known causes of market risk include economic recessions, shifts in interest rates and political unrest.
What are the different types of risk?
Market risk is further broken down into the following categories:
- Interest rate risk
- Equity price risk
- Foreign exchange risk
- Commodity price risk
Interest rate risk
Interest rate risk is usually applicable for investments in fixed-income securities. This risk comes from fluctuations in interest rates which may be due to several factors, such as changes in monetary policy. Depending on the diversity of the portfolio in question, interest rate risk can be further subdivided into four types.
Interest rate risks can fall under the following types:
- basis risk
- repricing risk
- yield curve risk
- options risk
If assets and liabilities with interests do not have the same bases, then this could be classified as a basis risk. For example, instead of the London Inter-bank Offered Rate (LIBOR), banks would use US prime rates as a basis for interest rates.
On the other hand, a repricing risk is a risk coming from repricing assets and liabilities at varying rates and times.
Yield curve risk is caused by variations in long-term and short-term interest rates.
Options risk is the risk coming from optionalities in assets and liabilities.
Equity price risk
If a specific risk is attributed to possible fluctuations in stock prices, this is known as equity price risk. There are certain kinds of equities, such as small cap stocks on emerging markets, which are considered to be more volatile compared to other equity types, while some stocks have increased levels of associated risks than those in other investment classes.
What is unsystematic risk?
Understanding equity price risk also means that business owners must understand the difference between systematic risk and unsystematic risk.
Systematic risks are risks which cannot be diversified and is caused by general market factors affecting the whole industry.
Unsystematic risks, on the other hand, are risks exclusive to a business and is caused by certain factors inside the business. Businesses can hedge against unsystematic risk via portfolio diversification.
Foreign exchange risk
Foreign exchange risks are risks which stem from volatility in currency exchange rates. Since political and social occurrences can cause exchange rates to rapidly fluctuate, these fluctuations can affect the profitability and margin of a specific business.
Businesses might be exposed to this particular risk if business owners fail to hedge properly, if not at all.
Commodity risk pertains to risks coming from fluctuations in commodity prices such as the price of oil or grain. Commodity risk can affect several sectors from producers to exporters and entire governments.
Commodity prices also have the tendency to remain high or low for long periods of time, which means risk exposure is more long-term compared to other kinds of risk.
How can risk be calculated?
Market risk is a constant among all industries: all kinds of businesses are exposed to risk regardless of how big or small a business is. This is why it is important for business owners to know how to do a proper market risk calculation since it will be a great help when making investment and business decisions.
There are also other ways by which business owners can mitigate business risk. Learn more about risk management here.
Two of the methods to calculate risk are the value-at-risk method and the beta risk metric.
The value-at-risk (VaR) method is a statistical method which quantifies the probability of the risk affecting the business as well as the potential portfolio loss. Although widely used, this particular method becomes less accurate when it comes to long-term investments because it assumes that the portfolio content remains constant throughout a given period.
The beta risk metric calculates the portfolio market risk and compares it to the overall market risk. This can be used to calculate the expected profit from an asset by incorporating the results into the capital asset pricing model (CAPM).
Another way for business owners to determine the probability of their business getting exposed to market risks is to avail the services of a market risk analyst. These professionals can assist business owners to risk management, accurately avoiding going into risk and decreasing the possibility of incurring losses for the business.