In a recent article, we detailed the differences between market risk and specific risk, commenting on how investors may use risk analyses of these distinctive kinds of risk to evaluate their future stock-picking choices. But, it is also important to point out that market risk and specific risk are merely blanket terms that encompass many other kinds of risks, categorized by how these risks might affect investors. Simply put, some risks that fall into the category of market risk, are much different than others. As investors, we know that it is important to not only evaluate the two major branches of risk but also to gain a better understanding of the more specific risk possibilities that fall into each of these categories. So, in this article, we have decided to delve a little bit deeper into the various kinds of risks that fall under the umbrella of market risk
Market risk – sometimes also called systematic risk – is the term used to describe the risks that occur as a result of changes in the markets. To evaluate these risks, investors typically research the various external factors affecting the markets. For example, market risk typically occurs as a result of large-scale events, such as national news that affects many industries. For this reason, the effects of market risk can generally be seen across a sizeable number of assets and a variety of asset classes. But, what do these risks look like in practice?
The four most common types of market risks include the following:
1. Interest Rate Risk
Interest rate risk refers to the volatility that typically occurs when interest rates change due to fundamental factors. An example of such a factor is central bank announcements. This risk heavily affects bonds specifically, as bonds’ prices are directly hinged on interest rate levels. However, interest rate risk is also very applicable to securities, as an increase in the market interest rate might cause investors to buy new securities that offer higher rates of return.
2. Equity Risk
The term ‘equity risk’ is commonly used to refer to the financial risk in holding an equity. Basically, this measure of risk is a factor of the security’s price and the length of time that an investor holds the security, assuming that the investor cannot use that money for other things while it is invested in a specific security.
3. Currency Risk
Currency risk – also sometimes called exchange-rate risk – is the risk that an investor might face as a result of the changes in the price of one currency in relation to another. This risk could occur as a result of national announcements that cause a country’s currency to fluctuate. Thus, by investing in the market of another country, an investor assumes the risk of the changing the exchange rate between that country’s currency and his or her own.
4. Commodity Risk
Finally, ‘commodity risk’ is a term used to define the changing prices of different commodities, such as steel, with reference to how these changes might affect the price of production for producers who use such inputs. For example, an unexpected change in commodity price can reduce a producer’s profit margin and negatively affect that company’s stock, impacting all of its investors.
Ultimately, because all of these types of risk are controlled by external forces – such as government announcements – it is typically very hard to diversify them away. However, the possibility of these risks is something that investors like to be aware of. Thus, if an investor is set on making a certain investment, he or she should definitely understand the inputs and factors that may affect the market that that investment is in. One of the greatest ways to evaluate market risk is to assess both the political and financial climates affecting the markets. As always, investors looking to make new investment decisions should know that most investments cannot come risk-free, but that understanding the possibilities of future risk can certainly help them to be better prepared in making their investment decisions!