Market risk is 

the risk of loss due to the factors that affect an entire market or
asset class. Market risk is also known as undiversifiable risk because it affects all asset
classes and is unpredictable. An investor can only mitigate this type of risk by hedging a
portfolio.

What is Market Risk?

The term market risk, also known as systematic risk, refers to the uncertainty
associated with any investment decision. Price volatility often arises due to
unanticipated fluctuations in factors that commonly affect the entire financial
market.

 Understanding Market Risk

Market risk and specific risk (unsystematic) make up the two major categories
of investment risk. Market risk, also called "systematic risk," cannot be
eliminated through diversification, though it can be hedged in other ways.
Sources of market risk include recessions, political turmoil, changes in
interest rates, natural disasters, and terrorist attacks. Systematic, or market
risk, tends to influence the entire market at the same time.

This can be contrasted with unsystematic risk, which is unique to a specific

company or industry. Also known as “nonsystematic risk,” "specific risk,"
"diversifiable risk" or "residual risk," in the context of an investment portfolio,
unsystematic risk can be reduced through diversification.

Market risk exists because of price changes. The standard deviation of

changes in the prices of stocks, currencies, or commodities is referred to as
price volatility. Volatility is rated in annualized terms and may be expressed
as an absolute number, such as $10, or a percentage of the initial value, such
as 10%.

Special Considerations
Publicly traded companies in the United States are required by the Securities
and Exchange Commission (SEC) to disclose how their productivity and
results may be linked to the performance of the financial markets. This
requirement is meant to detail a company's exposure to financial risk. 1  For
example, a company providing derivative investments or foreign exchange
futures may be more exposed to financial risk than companies that do not
provide these types of investments. This information helps investors and
traders make decisions based on their own risk management rules.

Other Types of Risk

In contrast to the market's overall risk, specific risk or "unsystematic risk" is
tied directly to the performance of a particular security and can be protected
against through investment diversification. One example of unsystematic risk
is a company declaring bankruptcy, thereby making its stock worthless to
investors.

The most common types of market risks include interest rate risk, equity risk,
currency risk, and commodity risk.

 Interest rate risk covers the volatility that may accompany interest rate

fluctuations due to fundamental factors, such as central bank
announcements related to changes in monetary policy. This risk is most
relevant to investments in fixed-income securities, such as bonds. 
 Equity risk is the risk involved in the changing prices of stock
investments,
 Commodity risk covers the changing prices of commodities such as
crude oil and corn.
 Currency risk, or exchange-rate risk, arises from the change in the price
of one currency in relation to another. Investors or firms holding assets
in another country are subject to currency risk.

Investors can utilize hedging strategies to protect against volatility and market

risk. Targeting specific securities, investors can buy put options to protect
against a downside move, and investors who want to hedge a large portfolio
of stocks can utilize index options.

Measuring Market Risk

To measure market risk, investors and analysts use the value-at-risk (VaR)
method. VaR modeling is a statistical risk management method that
quantifies a stock or portfolio's potential loss as well as the probability of that
potential loss occurring. While well-known and widely utilized, the VaR
method requires certain assumptions that limit its precision. For example, it
assumes that the makeup and content of the portfolio being measured are
unchanged over a specified period. Though this may be acceptable for short-
term horizons, it may provide less accurate measurements for long-term
investments.

Beta is another relevant risk metric, as it measures the volatility or market

risk of a security or portfolio in comparison to the market as a whole. It is
used in the capital asset pricing model (CAPM) to calculate the expected
return of an asset.

What's the Difference Between Market Risk and Specific

Risk?
Market risk and specific risk make up the two major categories of investment
risk. Market risk, also called "systematic risk," cannot be eliminated through
diversification, though it can be hedged in other ways, and tends to influence
the entire market at the same time. Specific risk, in contrast, is unique to a
specific company or industry. Specific risk, also known as "unsystematic risk",
"diversifiable risk" or "residual risk," can be reduced through diversification.

What Are Some Types of Market Risk?

The most common types of market risk include interest rate risk, equity risk,
commodity risk, and currency risk. Interest rate risk covers the volatility that
may accompany interest rate fluctuations and is most relevant to fixed-
income investments. Equity risk is the risk involved in the changing prices of
stock investments, and commodity risk covers the changing prices of
commodities such as crude oil and corn. Currency risk, or exchange-rate risk,
arises from the change in the price of one currency in relation to another. This
may affect investors holding assets in another country.

How Is Market Risk Measured?

A widely used measure of market risk is the value-at-risk (VaR) method. VaR
modeling is a statistical risk management method that quantifies a stock or
portfolio's potential loss as well as the probability of that potential loss
occurring. While well-known, the VaR method requires certain assumptions
that limit its precision. Beta is another relevant risk metric, as it measures the
volatility or market risk of a security or portfolio in comparison to the market
as a whole. It is used in the capital asset pricing model (CAPM) to calculate
the expected return of an asset.
 

Systematic risk is not specifically associated with the company or the industry
one is invested in; instead, it is dependent on the performance of the entire
market. Thus, it is necessary for an investor to keep an eye on various macro
variables associated with the financial market, such as inflation, interest rates,
the balance of payments situation, fiscal deficits, geopolitical factors, etc.

Summary

 The term market risk, also known as systematic risk, refers to the
uncertainty associated with any investment decision.
 The different types of market risks include interest rate risk,
commodity risk, currency risk, country risk.
 Professional analysts use methods like Value at Risk (VaR)
modeling, and the beta coefficient to identify potential losses via
statistical risk management.

Different Types of Market Risk

1. Interest Rate Risk

Interest rate risk arises from unanticipated fluctuations in the interest rates
due to monetary policy measures undertaken by the central bank. The yields
offered on securities across all markets must get equalized in the long run by
adjustment of market demand and supply of the instrument. Hence, an
increase in the rates would cause a fall in the security price. It is primarily
associated with fixed-income securities.

For example: Consider a situation where a sovereign bond offers a fixed

coupon payment of 6% p.a. on the principal value. Now, if the market interest
rate rises to 8%, the demand for the 6% bond will decline after a fall in the
prices, causing the Yield (Fixed – Coupon Payment / Market Price of Bond) to
rise until it is equal to 8%. Similarly, a decline in the market interest rate will
lead to an unanticipated gain in the security’s price.

 
2. Commodity Risk

Certain commodities, such as oil or food grain, are necessities for any
economy and compliment the production process of many goods due to their
utilization as indirect inputs. Any volatility in the prices of the commodities
trickles down to affect the performance of the entire market, often causing a
supply-side crisis.

Such shocks result in a decline in not only stock prices and performance-
based dividends, but also reduce a company’s ability to honor the value of the
principal itself.

3. Currency Risk

Currency risk is also known as exchange rate risk. It refers to the possibility of
a decline in the value of the return accruing to an investor owing to the
depreciation of the value of the domestic currency. The risk is usually taken
into consideration when an international investment is being made.

In order to mitigate the risk of losing out on foreign investment,

many emerging market economies maintain high foreign exchange reserves in
order to ensure that any possible depreciation can be negated by selling the
reserves.

4. Country Risk

Many macro variables that are outside the control of a financial market can
impact the level of return due to an investment. They include the degree of
political stability, level of fiscal deficit, proneness to natural disasters,
regulatory environment, ease of doing business, etc. The degree of risk
associated with such factors must be taken into consideration while making an
international investment decision.

 
How to Mitigate Market Risk

Because the risk affects the entire market, it cannot be diversified in order to
be mitigated but can be hedged for minimal exposure. As a result, investors
may fail to earn expected returns despite the rigorous application of
fundamental and technical analysis on the particular investment option.

Volatility, or the absolute/percentage dispersion in prices, is often considered

a good measure for market risk. Professional analysts also tend to use
methods like Value at Risk (VaR) modeling to identify potential losses via
statistical risk management.

The VaR method is a standard method for the evaluation of market risk. VaR
technique is a risk management method that involves the use of statistics that
quantifies a stock or portfolio’s prospective loss, as well as the probability of
that loss occurring. Although it is widely utilized, the VaR method requires
some assumptions that limit its accuracy.

The beta coefficient enables an investor to measure how volatile the nature or
market risk of a portfolio or security is, in comparison to the rest of the
market. It also uses the capital asset pricing model (CAPM) to calculate the
anticipated return of an asset.