For any business, trading comes with unavoidable, unpredictable risks. Among these is market risk, which is associated with losses due to unfavourable price movements in the markets where the business has exposure, such as financial or commodity markets. Market risk is also called systematic risk, and cannot be eliminated through diversification. It arises due mainly to changes in interest or exchange rates but can also occur as a result of natural disasters, geopolitical events, recessions or terrorist attacks. The main types of market risk are interest rate risk, equity risk, exchange rate risk and commodity price risk.
Interest rate risk refers to the volatile conditions which may be caused by changes in a country’s monetary policy, for instance, and is usually relevant to investments in securities. Equity risk occurs as a result of the change in price of stock investments, and commodity risk arises from the changing prices of commodities like crude oil, rubber, palm oil and grain. Exchange rate risk or currency risk arises when there is a change in the price of one currency in relation to another. Investors holding assets in another country are the most likely to suffer from exchange rate risk. Diversification of a portfolio cannot eliminate market risk, but investors may utilise hedging strategies for mitigation.
Before deciding what mitigation to set in place, the market risks which the business is exposed to needs to be measured. Besides having knowledge of market risk categories, organisations will need to understand measuring market risk methodology. One of these is the value-at-risk (VaR) method, which quantifies the potential loss of a stock or a portfolio of stocks, and the probability of that loss occurring. However, VaR does have limitations, one of them being the assumption that the content of the portfolio will not change over a specific period. This makes it appropriate for measurement over the short term but not when investments are long-term.
Another way to measure is by using Beta, which measures the volatility or market risk of a security or portfolio, in comparison to the market as a whole. Mitigating market risk requires organisations to be aware of market changes but this can be complicated as individual markets have their respective constraints, such as geographical boundaries. With exchange rate risk, for example, any change in the price of currency will make it less or more expensive to buy or maintain foreign assets. Companies dealing with commodities will also be affected. Currency risk or foreign exchange risk can increase the price of commodities like crude oil, iron ore, gas or wheat.
Considering that commodities are the basis of many other goods, commodity risk, too, could have far-reaching consequences. Most organisations recognise that taking certain risks are necessary and can provide long-term returns that make it worth their while, but they understand that caution still needs to be exercised as any market can suddenly turn volatile. Many of them turn to hedging – holding two or more positions simultaneously, so that any loss from one position may be balanced out with gains from another. They may also practise options trading, where the options holder has the right but not the obligation to buy or sell an asset at a set price, within a specified timeframe.
