 Personal finance PowerPoint presentation, market risk, prepare to get financially fit by practicing personal finance. We've been thinking about investment goals, investment strategies. As we do so, we have to consider risk. We've been breaking down different risk components which might have an impact on our investments and therefore of course have an investment on our strategy for investment. So we have inflation risk. During periods of high inflation, your investment return may not keep pace with inflation. So obviously there could be changes in the valuation of the dollar, the typical valuation of the dollar going down over time. Interest rate risk, we talked about in a prior presentation, the value of bonds or preferred stock may increase or decrease with changes in interest rate. Business failure risk affects stock and corporate bonds and now we're looking into the market risk, the risk of being in the market versus in a risk-free asset. Most of this information can be found at Investopedia Market Risk, which you can find online. Take a look at the references, resources, continue your research from there. This by Adam Hayes, updated March 10th, 2022. What is market risk? Market risk is the possibility that an individual or other entity will experience losses due to factors that affect the overall performance of investments in the financial markets. Key terms here being overall performance in the financial market. So if we have investments in the financial market and the entire market goes down, then we're still gonna have a problem even if we have diversification within the market diversification, usually be our major tool to mitigate or lower risk. Understanding market risk. Market risk and specific risk unsystematic make up 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. So in other ways, if we have diversification within the market, that's one way we typically hedge against risk. But if something happens that decreases the entire market, that diversification within it is not gonna safeguard us against that kind of risk. Sources of market risk include recession, political turmoil, changing in interest rates, natural disaster and terrorist attacks. And oftentimes you might see some of these in conjunction. We might have a terrorist attack and or a natural disaster for example that led to basically a recession. And the recession is typically a point in time that you have a decrease. So that's a point in time when you're saying there's no real good investments, the entire market is basically going down. 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. So unsystematic risk is the thing, the normal kind of circumstance where you might be saying, hey look, this particular industry, this particular company, it might not be the best circumstances for it given the market conditions but it might be a good circumstance for other industries, for other companies. In other words, conditions change all the time but generally those conditions will be more beneficial to certain industries, certain companies, less beneficial to others. Therefore, if we were to diversify within the market then we can basically lower that type of risk through that diversification. So it's also known as non-systematic risk, specific risk, diversifiable risk or residual risk in the context of investment portfolio, unsystematic risk can be reduced through diversification. Market risks exist 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, the SEC regulatory entity 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. 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, 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 quote, unsystematic risk in quote is tied directly to the performance of a particular security and can be protected against through investment diversification. So one example of unsystematic risk is a company declaring bankruptcy, thereby making its stock worthless to investors. So obviously, if a company is not performing well, they go bankrupt, then that's gonna be that one particular company. In that case, if you're diversified, then hopefully that's not gonna completely destroy your entire portfolio as opposed to a situation where basically the whole market is going down due to some particular circumstance. The most common types of market risk 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. We talked about interest rate risk in more detail in a prior presentation. Equity risk is the risk involved in the changing prices of stock investments. So when you're talking about the stock market, then the gains and losses are gonna be due to the fact that the stock prices are going up and down based on market conditions. Commodity risk covers the changing prices of commodities such as crude oil or corn. So when you're trying to invest in commodities, actual things, the things that have value themselves, then the prices of those things could change based on, again, market conditions, supply and demand. For example, currency risk or exchange rate risk arises from the change in the price of one currency in relation to another investor or firms holding assets in another currency are subject to currency risk. So if we have investments in another currency, now we've got differences in relations to our currency, say the US dollar and then the other currency, which is gonna have a risk component to it. Investors can utilize hedging strategies to protect against volatility and market risk. So 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. The two major market risk investors and analysts use the value at risk, the VAR method. VAR modeling is a statistical risk management method that quantifies a stock or portfolio's potential loss as well as the probability that potential loss occurring. So while well-known and widely utilized, the VAR method requires certain assumptions that limit its precision. For example, it assumes that the market and content of the portfolio being measured are unchanged over a specific period. Though this may be acceptable for short-term horizons, it may provide less accurate measurements for long-term investments. So obviously whenever we put in kind of a model that we're gonna be putting in place, then we have to make some kind of assumptions, some of those assumptions often being that there's gonna be some stability to some part of a timeframe, which again might work on the short-term, might have problems for the long-term. So 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, the 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 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, the VAR method. The 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. You might dive into that more in future presentations. While well-known, the VAR method requires certain assumptions that limits 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, the CAPM, to calculate the expected return on asset.