Market risks are threats investors face that are derived from conditions external to the investor him or herself. Market risk is sometimes referred to as systematic risk but is different from systemic risk.(2) To be more specific, market risk includes inherent uncertainties that can occur at any time regardless of preventative measures, whereas systemic risk is more influenced by controllable business variables rather than adjustments to individual investment strategy.
• Why market risk is mostly unavoidable
Market risk is unavoidable in any situation where an investor places money in a financial instrument such as stocks or bonds. Some financial instruments are exposed to less market risk than others, but all investments are not immune from market risk. For example, even government issued inflation protected securities are subject to risks having to do with the currency in which the securities pay interest. Inflation protection may be incorporated into the securities, but if that currency devalues against many other currencies, the purchasing power against those currencies can still decline.
• Types of market risk
A number of market risks exist, some of which are more probable than others depending on the type of investment and the market environment in which the investments are made. (1) For example, the above section states currency risk depreciates the value of inflation protected securities, but what if the currency is stable, or goods purchased with the currency are cheaply made and acquired domestically? The answer is other risks such as interest rate risk may also apply. Since interest rates are subject to economic conditions, in the case of floating rate inflation protected securities, they could still decline in interest payments even if inflation rises.
• How market risk affects investments
Market risk affects investments by making them worth less, but risk sometimes can preclude higher returns. Risk can also be priced into securities so that the more cautious investor feels they are exposing themselves to less market risk. An example of this is a risk premium added to bonds that are rated lower than investment grade; another word for these bonds is 'junk bonds'. Market risk can also cause volatility in the value of an investment such as stocks. For example, if economic conditions change, and the industry in which stocks are held is affected by that change in economic climate, then the risk of business failure or profit decline emerges.
• Methods for dealing with market risk
Apart from industry regulation,(5) market risk can be limited through risk management methods such as investment techniques, calculated selection and market analysis. Just as one would not go out in a hurricane to buy a bag of apples, investing in certain market conditions is like walking into a hurricane. By studying the market, the specific risks that investments pose and ways to hedge against those risks, market risk can be reduced. Common techniques for risk reduction in include diversification and investment in FDIC insured accounts. The reasons why diversification is thought to be effective in reducing market risk is because it spreads out investment over a number of industries or businesses. However, it is important to note than in macro-economic instability, even diversification can fail.
• Measuring market risk
Market risk can be measured in a number of ways. According to the Financial Times, Systematic indices exist that keep track of risk levels of various investments.(3) Moreover, these indices specifically measure performance of investments that are known to be vulnerable to different kinds of risks. For example, a fund that trades currencies is not necessarily subject to the same risks as a fund that invests in precious metals. Several other methods of measuring risk also exist, and for example, they may involve risk formulas(4) or qualitative evaluation of business management.
• Why market risk is mostly unavoidable
Market risk is unavoidable in any situation where an investor places money in a financial instrument such as stocks or bonds. Some financial instruments are exposed to less market risk than others, but all investments are not immune from market risk. For example, even government issued inflation protected securities are subject to risks having to do with the currency in which the securities pay interest. Inflation protection may be incorporated into the securities, but if that currency devalues against many other currencies, the purchasing power against those currencies can still decline.
• Types of market risk
A number of market risks exist, some of which are more probable than others depending on the type of investment and the market environment in which the investments are made. (1) For example, the above section states currency risk depreciates the value of inflation protected securities, but what if the currency is stable, or goods purchased with the currency are cheaply made and acquired domestically? The answer is other risks such as interest rate risk may also apply. Since interest rates are subject to economic conditions, in the case of floating rate inflation protected securities, they could still decline in interest payments even if inflation rises.
• How market risk affects investments
Market risk affects investments by making them worth less, but risk sometimes can preclude higher returns. Risk can also be priced into securities so that the more cautious investor feels they are exposing themselves to less market risk. An example of this is a risk premium added to bonds that are rated lower than investment grade; another word for these bonds is 'junk bonds'. Market risk can also cause volatility in the value of an investment such as stocks. For example, if economic conditions change, and the industry in which stocks are held is affected by that change in economic climate, then the risk of business failure or profit decline emerges.
• Methods for dealing with market risk
Apart from industry regulation,(5) market risk can be limited through risk management methods such as investment techniques, calculated selection and market analysis. Just as one would not go out in a hurricane to buy a bag of apples, investing in certain market conditions is like walking into a hurricane. By studying the market, the specific risks that investments pose and ways to hedge against those risks, market risk can be reduced. Common techniques for risk reduction in include diversification and investment in FDIC insured accounts. The reasons why diversification is thought to be effective in reducing market risk is because it spreads out investment over a number of industries or businesses. However, it is important to note than in macro-economic instability, even diversification can fail.
• Measuring market risk
Market risk can be measured in a number of ways. According to the Financial Times, Systematic indices exist that keep track of risk levels of various investments.(3) Moreover, these indices specifically measure performance of investments that are known to be vulnerable to different kinds of risks. For example, a fund that trades currencies is not necessarily subject to the same risks as a fund that invests in precious metals. Several other methods of measuring risk also exist, and for example, they may involve risk formulas(4) or qualitative evaluation of business management.
Sources:
1. http://bit.ly/aEUUxt (FINRA)
2. http://bit.ly/cJfwfw (Investopedia)
3. http://bit.ly/b2MMMm (Financial Times)
4. http://bit.ly/bogSd2 (University of Wisconsin)
5. http://bit.ly/anZomF (SEC)
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