What is Market Risk?
Market risk, also known as “systematic risk,” refers to the potential financial losses that can arise from changes in market prices. This risk is inherent in all market-related activities and cannot be completely avoided. Market risk can affect an individual stock, a segment of the market, or the market as a whole. Examples of market risk include changes in equity prices, interest rates, foreign exchange rates, and commodity prices. Financial instruments like futures contracts and options can be used to hedge this risk, though they can’t completely eliminate it.
Examples of Market Risk
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Equity Price Risk: This occurs when the prices of shares in a stock market fluctuate. For instance, an investor buying shares in a company may face losses if the stock market declines.
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Interest Rate Risk: When interest rates change, the value of bonds and other debt instruments can be affected. For example, when interest rates rise, bond prices typically fall.
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Currency Risk: Investors and businesses dealing in foreign currencies are exposed to currency risk. For example, if a U.S. company receives payments in euros, a decrease in the value of the euro against the U.S. dollar will reduce the company’s revenue.
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Commodity Price Risk: The prices of commodities like oil, gold, and agricultural products can be very volatile. For instance, an airline company could face increased fuel costs if oil prices rise.
Frequently Asked Questions (FAQs)
What are the main types of market risk?
The main types of market risk include equity risk, interest rate risk, currency risk, and commodity risk. Each type is linked to price fluctuations in financial markets.
Can market risk be completely eliminated?
No, market risk cannot be completely eliminated. It can, however, be mitigated through hedging strategies using instruments like futures and options.
How can one hedge against market risk?
Hedging against market risk can be done using financial instruments such as futures contracts, options, swaps, and other derivatives. Diversifying investments also helps to spread the risk.
What is the difference between market risk and credit risk?
Market risk pertains to losses due to changes in market prices, while credit risk refers to the risk of loss due to a borrower’s failure to make payments as agreed.
Why is market risk considered systematic?
Market risk is considered systematic because it affects the entire market rather than just one specific asset or asset group.
Related Terms
- Hedge: A strategy used to offset potential losses or gains in investments by taking an opposite position in a related asset.
- Futures Contracts: Financial contracts obligating the buyer to purchase, or the seller to sell, a particular asset at a predetermined future date and price.
- Options: Financial derivatives that provide the buyer the right, but not the obligation, to buy or sell an asset at a specified price within a certain period.
Online References
Suggested Books for Further Studies
- “Options, Futures, and Other Derivatives” by John C. Hull
- “Financial Risk Management: A Practitioner’s Guide to Managing Market and Credit Risk” by Steve L. Allen
- “Market Risk Analysis” (Four Volume Set) by Carol Alexander
Accounting Basics: “Market Risk” Fundamentals Quiz
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