Market risk

One of the major aims of many financial institutions is the generation of profits through investment in global financial markets. This business, by its nature, is based on price uncertainty – the uncertainty of knowing whether market prices will move in a favourable or adverse direction.

Price uncertainty is the mechanism that allows profits or losses to be made, and the risk of loss associated with it is known as market risk. This risk reflects the uncertainty of an asset’s future price. The factors affecting market risk are complex. For instance, there are direct and indirect market risk factors to consider. when investing in a company’s shares  Direct market risk factors directly reflect a company’s performance, such as the health of its balance sheet, its vision, and the strength of its management team. Indirect factors indirectly affect a company’s performance, such as interest rate levels, economic events, political, sector sentiment, and environmental effects. 

The financial services sector takes advantage of market risk to make a profit. Managing this risk is not to eradicate it but to understand and quantify it. If this is done accurately, an informed decision can be made on how acceptable the risk is and, hence, whether it is a worthwhile investment. As there are vast profits to be made in getting this right, financial institutions have invested heavily in research, tools, and expertise to predict the future performance of their investments. 

Understanding this market risk is also essential in pricing financial products, such as futures and options. For these reasons, the methods and tools used for measuring market risk have become very advanced, involving cutting-edge mathematical theory and computer processing technology. This article provides a basic understanding of these methods and tools and explains how they fit into an overall risk management strategy. 

Market risk can be defined as: ‘The risk of loss arising from changes in the value of financial instruments’.

Market risk can be sub-divided into the following types: 

1. Volatility Risk 

Volatility risk is the risk of price movements that are more uncertain than usual, affecting the pricing of products. All priced instruments suffer from this form of volatility. This mainly affects options pricing because if the market is volatile, then the pricing of an option is more complicated, and options will become more expensive.

2. Market Liquidity Risk 

In market risk, this is the risk of loss through not being able to trade in a market or obtain a price on the desired product when required. Market liquidity risk can occur in a market due to either a lack of supply or demand or a shortage of market makers.

3. Currency Risk 

Adverse movements in exchange rates cause this. It affects any portfolio or instrument with cash flows denominated in a currency other than the firm’s base currency. Currency risk is also inherent when trading cryptocurrencies. These are digital currencies in which encryption techniques regulate the generation of currency units and verify the transfer of funds, operating independently of a central bank. Cryptocurrencies often display far higher volatility than so-called fiat currencies.

4. Basis Risk 

This occurs when one risk exposure is hedged with an offsetting exposure in another instrument that behaves similarly, but not identical, manner. If the two positions were truly ‘equal and opposite’, then there would be no risk in the combined position. Basis risk exists so that the two positions do not precisely mirror each other. 

5. Interest Rate Risk 

This is caused by adverse movements in interest rates and will directly affect fixed income securities, futures, options and forwards. It may also indirectly affect other instruments.  

6. Commodity Price Risk 

This is the risk of an adverse price movement in the value of a commodity. The price risk of commodities differs considerably from other market risk drivers because most commodities are traded in markets where the concentration of supply in the hands of a few suppliers can magnify price volatility. 

Fluctuations in the depth of trading in the market (i.e., market liquidity) often accompany and exacerbate high levels of price volatility. Other fundamentals affecting a commodity’s price include the ease and cost of storage, which varies considerably across the commodity markets (eg, from gold to electricity, to wheat). As a result of these factors, commodity prices generally have higher volatilities and more significant price discontinuities (i.e., moments when prices leap from one level to another) than most traded financial securities. 

7. Equity Price Risk 

The returns from investing in equities come from: 

• capital growth – if a company does well, the price of its shares should go up 
• income – through the distribution by the company of its profits as dividends. 

Therefore, investing in equities carries risks that can affect: 

• the capital – the share price may fall or fail to rise in line with inflation or with the performance of other, less risky investments 
• the income – if the company is not as profitable as hoped, its dividends may not keep pace with inflation; indeed, they may fall or even not be paid. Unlike bond coupons, dividend payments are not compulsory

Boundary Issues

Many of the constituent market risk elements described above are related. For example: 

• liquidity risk could be caused by a lack of supply or demand – which also causes price level risk 
• an increase in volatility risk will exacerbate price level risk for investors wishing to buy or sell 
• interest rate risk will indirectly affect the real economy and the markets. 

These boundary issues mean that it is not straightforward to analyse precisely which factors are causing which movements.

Market Risk Examples

As discussed above, three key drivers of market risk are currency, interest rate and liquidity risks. Some concrete examples will help to apply the concepts to the real world. 

1. Currency Risk 

A UK investor purchases an equity portfolio in the US. In dollars, the investment provides a positive return of 10%, but because the dollar loses 8% of its value against the pound, the investor’s return is only 2%. 

2. Interest Rate Risk 

An investor purchases a long-term bond in the UK, hoping to sell it at a profit in the future. Bond prices move inversely to interest rate moves, so if interest rates increase, the price of bonds will fall. For short-term bonds (less than three years), the price change will be relatively minor compared to the change in price for a long-term bond (more than ten years). This is because longer-term bonds are generally more volatile. After all, the distant future is unknown and, therefore, riskier. 

3. Liquidity Risk 

An investor purchases a commercial property to rent out. Because of liquidity issues in the property market, it takes much longer to sell again – even reducing the price may not help if no one else wants to own the property or if it becomes difficult to obtain credit for a mortgage.

Market Risk Management Techniques and their Application

1. Hedging 

Hedging reduces the risk of adverse price movements by taking an offsetting position in a related product. It is a means of insuring against market risk. The main financial instruments used in hedging are derivatives, particularly futures and options. For instance, an investor who has bought equity is at risk of losing money if the market declines. This risk could be hedged by buying a put option, costing a fraction of the price of the equity investment.

This option gives the investor the right, but not the obligation, to sell the stock at a set price (the strike price) within a particular time in the future. The investor is now protected against adverse market movements. The decision to hedge is a trade-off between the risk of adverse market movements and the cost of the hedge – in this case, the option’s purchase price. However, it is difficult to achieve perfect offsetting of the risk. Hedging introduces or exacerbates other risks such as basis risk (described earlier), credit risk and operational risk. 

2. Market Risk Limits 

Market risk limits are used to manage market risk in the same way that credit limits protect firms from credit risk. When an organisation takes a risk, it will often specify the maximum loss that it is prepared to make on a portfolio or transaction. This is called the market risk limit or stop-loss limit and may be expressed in terms of value at risk or as an absolute number of the instrument being traded. 

The effectiveness of risk limits to manage market risk depends on the accuracy of the risk measurement used to set the limits. The potential problems of using over-simplified risk measurement are: 

• risk limits usually have to be inflated to accommodate the errors and uncertainty in the measurement. This adversely affects the potential profit of the firm. 
• traders or other investment professionals may exploit the inaccuracy of risk measurement and take risks that they know the measurement does not account for. 

If high-quality risk data is used, risk limits can be very effective. While investment professionals sometimes see them as restrictive, they can also be viewed as empowering because they set the firm’s risk appetite and represent explicit authority to take specified levels of risk. For electronic trading, position limits are a highly effective mitigant against market risk because machines can trade up to, but not beyond, the limit with great speed and accuracy. 

3. Diversification 

Their respective standard deviation of returns gives the market risk of holding two securities in isolation. However, by combining these assets in varying proportions to create a two-stock portfolio, the portfolio’s standard deviation of return will, in almost all cases, be lower than the weighted average of the standard deviations of these two individual securities. 

The weightings are given by the proportion of the portfolio held in each security. This reduction in risk for a given level of expected return is due to the effects of diversification. A straightforward example of diversification would be to combine shares in a sun cream factory with shares in an umbrella business. The sun cream factory does well when the summers are hot, while the umbrella business does well on rainy days. Although the earnings of each business can be volatile, the combined earnings will be less so because of the inverse relationship or negative correlation between their earnings. 

Of course, most portfolios hold more than two stocks, so the correlation quantifies the diversification potential of various multi-stock combinations. Diversification is achieved by combining securities whose returns ideally move in the opposite direction or, if in the same direction, at least not to the same degree. 

4. High-Frequency Trading (HFT) 

In recent years, a new kind of trading has emerged that uses mathematical models to predict the market price of securities over the next few minutes or hours. These models are run on high-speed computers co-located within a market’s data centre; this gives a speed advantage that enables liquid positions to be unwound at short notice. This allows such firms to offer tight spreads to the benefit of other participants. It also allows high-frequency trading firms to turn over very high volumes of trades throughout the day. The result is that they only need to earn a small amount per trade which enables small position limits to be employed. This combination of small position limits and fast liquidation time drastically reduces the level of market risk that needs to be taken, which means that such firms can act as market makers, committing to transacting a minimum volume of trades throughout the day. 

Other HFT firms pursue speed above all else rather than developing economic price-prediction models. Such firms need to invest heavily in infrastructure, such as microwave links, to outperform the fibre networks used by most other market participants. However, speed alone is not a sustainable advantage because competitor firms can replicate it with the ability to invest in the necessary computer and telecoms hardware. In addition, price prediction models allow HFT firms to hold positions for minutes or even hours, whereas pure-speed HFT firms hardly hold their positions for any time at all. Flash crashes are sometimes blamed on general HFT activity in the popular media because the distinction between the two types of HFT firms is not always well understood.

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