A guide to market risk

Before you start trading, it’s important to understand the potential risks involved. Let’s take a look at the different types of market risks.

What is market risk?

Market risk is the possibility that an individual – such as an investor or trader – or an entity – such as a company – will experience a financial loss due to the changing value of an investment or asset.

Market risk is often used broadly, but it describes the more systemic risk factors that impact an entire market’s performance – such as geopolitical events, interest rates and economic health. Whereas unsystematic risk or ‘specific risk’, describes the factors that impact a single asset, or a risk that an investor chooses to take on, such as trading on margin.

Let’s take a look at the different types of risk in more detail.

Types of market risk

Volatility risk

Most market risk exists due to changes in a market’s price. When these changes are large and over a smaller timeframe, it’s known as volatility.

Volatility itself isn’t necessarily a risk, as traders can use it to find opportunities. However, when markets are moving quickly and drastically, the risk to the trader does increase.

That’s why it’s vital to manage your risk appropriately, using stop-loss orders to prevent losses from running if the market turns against your trade. 

Liquidity risk

Liquidity is how easily an asset can be bought or sold. Liquidity risk occurs when it there aren’t enough counterparties trading on the market to take the other side of a position, resulting in an inability to easily exit a trade.

Some markets have a greater liquidity risk than others. For example, forex is a liquid market due to the high daily trade volumes, whereas some small-cap stocks may be harder to trade.

Interest rate risk

Interest rate risk describes the volatility that can occur when interest rate decisions are made – usually when a central bank announces changes to a country’s monetary policy.

This type of risk is more relevant to fixed-income securities, such as bonds, but as interest rates can impact the view of a country’s economy, fluctuations can occur in currencies, indices and shares too.

To manage interest rate risk, it’s important to keep an eye on any upcoming announcements. You can do this using an economic calendar.

Counterparty risk

Counterparty risk is the probability that the other party in an investment won’t fulfil their side of the deal and end up defaulting on their contractual obligations.

For investors, most counterparty risk considerations are regarding bonds. Bonds are rated by agencies, such as Moody’s and Standard and Poor’s, to gauge the level of counterparty risk. They rank them from AAA to junk bond status. Bonds that have a lower status, meaning that they carry higher counterparty risk, will need to pay higher yields to entice investors. When a country has a higher status, the counterparty risk is minimal, and so the premiums or interest rates are lower.

Types of specific risk

Exchange rate risk

Currency risk, or exchange rate risk, arises from the strengthening or weakening of one currency relative to another.

Although most exchange rate risk exists for currency traders, it can have serious consequences for investors or companies holding foreign assets – such as shares or bonds – as any profit or loss must be converted into their local denomination. Significant fluctuations in exchange rates could fundamentally change the value of the capital received.

Stock market risk

Stock market risk – also known as equity risk – is the probability that stock or stock indices will change in price and cause an investor’s portfolio to reduce in value.

To measure equity risk, traders will typically look at the standard deviation in a stock’s price over a period of time. Longer-term investors won’t consider deviations ‘risk’ as they look at the overall trend, ignoring fluctuations. But short-term traders will need to be aware of stock volatility.

Commodity market risk

Commodity market risk is the term for the changing prices of resources such as energies, metals and agricultural products.

Given that a lot of commodities are necessary for the production chains and the economy at large, volatility in their prices can have knock-on effects for everyone from companies to consumers.

Margin risk

Margin risk is the possibility that a leveraged account – such as a CFD account -runs low on funds and no longer has enough capital to keep positions open.

This usually happens because of a losing trade, which has reduced the account balance below the minimum level required. This is also known as margin call, and the trader will need to add additional capital to keep their trades going.

Margin trading comes with a variety of other risks, such as the possibility your losses will be magnified. That’s because although you only need a small initial deposit to open a position, your trade outcomes will be based on the full market exposure.

Calculating market risk

To calculate or measure market risk, investors and analysts typically use the value-at-risk (VaR) method.

VaR is a statistical measurement of a portfolio’s potential loss and the probability of this loss taking place over a period of time.

For example, if the 95% one-month VAR is $1000, there is 95% confidence that over the next month, the portfolio will not lose more than $1,000.

There are a number of ways to use VaR. The historical method looks at the history of the previous returns and orders them from worst losses to greatest gains. It’s the idea that previous returns can inform future outcomes.

The variance-covariance method doesn’t rely on historical data, instead, it assumes that gains and losses are distributed around a mean. These deviations from the average can therefore be estimated and used to make projections of future losses.