What Are the Primary Sources of Market Risk?

Market risk is the risk of loss due to the factors that affect an entire market or asset class. Market risk is also known as undiversifiable risk because it affects all asset classes and is unpredictable. An investor can only mitigate this type of risk by hedging a portfolio. Four primary sources of risk affect the overall market: interest rate risk, equity price risk, foreign exchange risk, and commodity risk.

Interest Rate Risk

Interest rate risk is the risk of increased volatility due to a change in interest rates. There are different types of risk exposures that can arise when there is a change of interest rates, such as basis risk, options risk, term structure risk, and repricing risk.

Basis risk is a component due to possible changes in spreads when interest rates are fluctuating. Basis risk arises when there are changes in the spread between different markets' interest rates.

Equity Price Risk

Equity price risk is the risk that arises from security price volatility – the risk of a decline in the value of a security or a portfolio. Equity price risk can be either systematic or unsystematic risk. Unsystematic risk can be mitigated through diversification, whereas systematic cannot be. In a global economic crisis, equity price risk is systematic because it affects multiple asset classes.

A portfolio can only be hedged against this risk. For example, if an investor is invested in multiple assets that represent an index, the investor can hedge against equity price risk by buying put options in the index exchange-traded fund.

Foreign Exchange Risk

Currency risk, or foreign exchange risk, is a form of risk that arises when currency exchange rates are volatile. Global firms may be exposed to currency risk when conducting business due to imperfect hedges.

For example, suppose a U.S investor has investments in China. The realized return will be affected when exchanging the two currencies. Assume the investor has a realized 50% return on investment in China, but the Chinese yuan depreciates 20% against the U.S. dollar. Due to the change in currencies, the investor will only have a 30% return. This risk can be mitigated by hedging with currency exchange-traded funds.

Commodity Risk

Commodity price risk is the volatility in market price due to the price fluctuation of a commodity. Commodity risk affects various sectors of the market, such as airlines and casino gaming. A commodity's price is affected by politics, seasonal changes, technology, and current market conditions.

For example, suppose there is an oversupply of crude oil, which has caused oil prices to fall every day over the past six months. A company that is heavily invested in oil drilling wells faces commodity price risk. The company's profit margin will fall as well since it is still operating at the same cost, but the prices of crude oil are falling. Its profits will decrease. The company could use futures or options to hedge this risk and minimize the uncertainty of oil prices.

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