Market Risk Definition: How to Deal With Systematic Risk

What Is Market Risk?

The term market risk refers to the potential for losses that may arise from financial market fluctuations. Put simply, it is the risk of market price and interest rate movements. Market risk, which is also called systematic risk, is often the result of market prices, interest rates, exchange rates, and other factors. Regardless of what an investor does, market risk cannot be avoided or eliminated but it can be mitigated through different strategies.

Understanding Market Risk

As noted above, market risk is the potential that entities may experience for financial losses stemming from changes in market prices. The standard deviation of changes in the prices of stocks, currencies, or commodities is referred to as price volatility. Volatility is often presented in annualized terms and may be expressed as an absolute number, such as $10, or a percentage of the initial value, such as 10%.

Various factors can affect market risk, including recessions, political turmoil, changes in interest rates, natural disasters, and terrorist attacks. Systematic risk, which is another term for market risk, tends to influence the entire market at the same time.

Although you can't eliminate market risk, you can mitigate or manage it using different investment strategies, including:

• Diversification: You can reduce market risk by making investments across different asset classes, industries, sectors, and countries. The goal is that if one investment's performance drops, the other(s) will compensate.
• Hedging: Hedging involves investing in an asset that moves in an opposite direction from another. For instance, investing in gold to counter the movement in the U.S. dollar.
• Active portfolio management: This strategy involves closely monitoring your portfolio and making changes regularly based on market conditions.

Other Types of Risk

Market risk can be contrasted with unsystematic risk, Unlike market risk, unsystematic risk is unique to a specific company or industry. Also known as nonsystematic risk, specific risk, diversifiable risk, or residual risk, it can be mitigated through diversification. One example of unsystematic risk is a company declaring bankruptcy, thereby making its stock worthless to investors.

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 may accompany interest rate fluctuations due to fundamental factors, such as central bank announcements related to changes in monetary policy. This risk is most relevant to investments in fixed-income securities, such as bonds. 
• Equity risk is the risk involved in the changing prices of stock investments.
• Commodity risk covers the changing prices of commodities such as crude oil and corn.
• Currency risk or exchange-rate risk arises from the change in the price of one currency to another. Investors or firms holding assets in another country are subject to currency risk.

Managing Market Risk

If you invest, there is no single way to completely avoid market risk. But, you can use hedging strategies to protect against volatility and minimize the impact that market risk will have on your investments and overall financial health.

For example, you can buy put options to protect against a downside move when targeting specific securities. Or, if you want to hedge a large portfolio of stocks, you can utilize index options. Consider using a variety of these strategies to manage market risk and protect your portfolio.

Study Currency Profiles

If you invest in foreign markets, pay attention to the currency profiles of the companies in which you invest. Industries that import more will be impacted by changes to the local currency. Industries that export more will be affected by changes to the value of the euro or dollar.

Allocate your assets across a variety of industries to mitigate risk, and invest 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 shift your investments to account for interest rate changes. For example, if you are heavily invested in bonds and interest rates are rising, you may want to tweak your investments to focus on shorter-term bonds.

Maintain Liquidity

When markets are volatile, you may have trouble selling or buying an asset within your price range, especially when you need to exit a position in a hurry. If the market is crashing, liquidity may be difficult no matter what type of stocks you buy. Under more normal conditions, though, you can maintain your liquidity by sticking with stocks that have low impact cost (the cost of a transaction for that stock) to make trading easier.

Invest in Staples

Some industries tend to do well even when the overall economy is poor. These tend to be utilities and businesses producing consumer staples. That’s because no matter what the economy is doing, people still need to turn their lights on, still need to eat, and still need toilet paper and toothpaste. By keeping some of your money in staples, you can still see returns in a recession or a period of high unemployment.

Think Long Term

No matter where you invest your money, you can't fully escape market risk and volatility. But you can manage this risk and escape much of the impact of volatile markets by using a long-term investing strategy. You may want to make small tweaks in response to changes in the market. But don’t up-end your entire investing strategy because a recession hit or a currency changed value.

Short-term traders are generally more impacted by volatility. Volatility tends to even out over time. By approaching your investing systematically, and sticking with a long-term outlook and strategy, you are more likely to see your portfolio bounce back from the impact of market risks.

Measuring Market Risk

To measure market risk, investors and analysts often use the value-at-risk (VaR) method. VaR modeling is a statistical risk management method that quantifies a stock’s or portfolio’s potential loss as well as the probability of that potential loss occurring. While well-known and widely utilized, the VaR method requires certain assumptions that limit its precision.

For example, it assumes that the makeup and content of the portfolio being measured are unchanged over a specified period. Though this may be acceptable for short-term horizons, it may provide less accurate measurements for long-term investments.

Value at Risk (VaR)

VaR is a statistical measure that calculates the maximum potential loss a portfolio could experience over a given period at a certain level of confidence. So, a VaR of 95% suggests that there is a 95% chance that the portfolio would not lose more than the calculated amount over the given period.

• The historical method for computing VaR looks at one’s prior returns history and orders them from worst losses to greatest gains—following from the premise that past returns experience will inform future outcomes.
• The variance-covariance method (also called the parametric method) does not look backward but instead assumes that gains and losses are normally distributed. Potential losses are framed in terms of the number of standard deviations from the mean.
• Monte Carlo simulation uses computational models to simulate projected returns over hundreds or thousands of possible iterations. Then, it estimates the chances that a loss will occur to compute the VaR—say, what the maximum loss would be 5% of the time.

Risk Premium

The equity risk premium (ERP) is a measure of market risk that reflects the excess return that investors demand for investing in stocks over and above the risk-free rate of return (ROR). In other words, it is the implied additional compensation that investors require to hold an investment in the broader stock market, which is inherently riskier than holding a risk-free asset like U.S. Treasuries.

The ERP is calculated by subtracting the risk-free ROR (usually a short-term or midterm government bond yield) from the expected return on the stock market. For example, if the expected return on the stock market is 10% and the risk-free rate is 2%, the ERP would be 8%.

The difference between the broader market risk premium (MRP) and the equity risk premium comes down to scope. The ERP is specific to the stock market, while the MRP is the additional return that’s expected on a diversified portfolio of investments held among various asset classes that is above the risk-free rate.

The Bottom Line

Market risk is the chance of incurring losses due to factors that affect the overall performance of financial markets. Events like changes in interest rates, geopolitical events, or recessions can bring on what is known as the pain trade. It is called systematic risk since it cannot be eliminated through diversification. Specific risk, on the other hand, is unique to a particular stock or industry sector and can be minimized through diversification.