Market Risk

 

RISK

Our life is full of risks. Everyone in some way or other comes across a risk . We often hear  people around us saying “This investment is a risk” or “I took a risk by moving to a new country”. But what exactly is a risk? There are various ways to define it. However, the simplest explanation of risk is “the possibility of something bad happening.” 

Risks come in all shapes and sizes. Financial risks are in the more prominent types of risks. People are hesitant in making investments with good returns as they are reluctant to bear the risk due to insufficient knowledge of risk management which makes it necessary to educate ourselves about these financial risks and learn to manage them for our financial independence.


MARKET RISK


One of the most crucial financial risks is “Market Risk”. As the name suggests, it is a risk that affects the entire financial market i.e. it affects entire industries as a whole. Basically, it is the risk of facing losses due to unfavorable changes in the market affecting the prices of various assets, liabilities and derivatives.

This risk can be better explained with the help of an example. Due to the pandemic as well as globalization, more and more people are opting to buy things on the internet. Hence, we can see a rise in the number of businesses selling their product online rather than in traditional stores. The shops and businesses which did not adapt to this new market environment, suffered huge losses. Thus, the pandemic and the increase in the number of online stores was a risk that affected the entire financial market and not only a specific country or a specific sector of the market. Other examples of market risk are recession or changes in the interest rate etc.


Types of market risk:-


1.Absolute risk

Absolute risk is the probability of a certain unfavorable event occurring without any conditions or bias. For instance, If an investment is made in a Bond, there is risk of default at the time of payment.  There is a certain level of risk without relation to the occurrence or non-occurrence of events or some condition.


2. Relative Risk 

Relative risk is where the risk is evaluated with respect to different conditions. Here the level of risk is in relation with a certain condition. For instance, If there is an increase in the taxes on imported goods, the loss suffered (i.e. the risk) will be huge if an organization imports a huge amount of goods and relatively less with less imports.


3. Directional Risk

It means that when our investment is subject to a risk of loss in proportion to change in the direction of prices or interest rates. 

For instance, Shares of a company were bought by an investor with an expectation to sell the shares when the price rises. However, due to some unfavorable event the the share price falls down and the investor may have to sell the shares at a lower price than anticipated. The investor’s loss is proportional to the decrease in the price of the share.


4 Non-directional risk

Non-directional risk is the non-linear relation between financial variables. For instance, When the tax on a commodity is increased by a small percentage, the sales of that commodity are negatively affected at a percentage much greater than the increase in its tax.


5. Basis Risk

Basis risk is the risk that arises when a hedged investment is ill-matched. If an investment is hedged with respect to a certain asset then the difference between them is a basis risk.

For instance, If an agreement is made between a manufacturing company and a raw material provider that they will provide the raw material at the price of $10 per piece at a specified future date. However, at the specified future date if the price of raw material is $9. Then the difference of $1 is the basis risk.

Huge losses can be suffered if the transactions are of huge quantities.



6. Volatility Risk

Volatility risk is the risk that arises when there occurs a change in the price of the investment due to change in the volatility of the underlying asset. For instance, Prices of sugar can change drastically if the prices of sugarcane change and thereby affect the profits of the investors of a sugar manufacturing company.

 

Market risk is just the tip of the iceberg and there are several other financial risks that make it essential to learn about and manage them.


Sources 

  1. https://www.piranirisk.com/blog/4-types-of-financial-risks

  2. https://www.simplilearn.com/financial-risk-and-types-rar131-article

  3. https://kalyan-city.blogspot.com/2012/01/types-of-risk-systematic-and.html

  4. https://capital.com/basis-risk-definition

  5. https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/what-is-basis-risk/


~ Suhani Kulkarni

Comments

  1. UnknownNovember 10, 2021 at 9:26 AM

    Superb Beta
    you can enlight the present scenario of pendamic crisis too

    ReplyDelete

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