market risk

Examples of market risk in the following topics:

• The Relationship Between Risk and Return and the Security Market Line

  • Investment assets are typically characterized as having two performance risks: systematic (or market risk) and non-systematic risk.
  • Systematic risk arises from market structure or dynamics, which produce shocks or uncertainty faced by all agents in the market.
  • The expected return of an asset is equal to the risk free rate plus the excess return of the market above the risk-free rate, adjusted for the asset's overall sensitivity to market fluctuations or its beta.
  • The market risk premium is determined from the slope of the SML.
  • The intercept is the nominal risk-free rate available for the market, while the slope is the market premium, E(Rm)− Rf.

• Types of Risk

  • There are many types of financial risk, including asset-backed, prepayment, interest rate, credit, liquidity, market, operational, foreign, and model risk.
  • Some investments (i.e. stocks) can be sold immediately at the current market rate and others (i.e. houses) are subject to a much higher degree of liquidity risk.
  • Market risk is the term associated with the risk of losing value in an investment will lose value because of a decline in the market.
  • Foreign investment risk involves the risk associated with investments in foreign markets.
  • A recent phenomenon that applies the concepts of these risks and how they interact with each other happened in 2008 when the housing market crashed.

• The Capital Asset Pricing Model

  • Systematic risk - also called market risk or non-diversifiable risk - represents the risk present in a security in relation to the economy as a whole.
  • Unsystematic risk - also called idiosyncratic risk or diversifiable risk - represents the risk present in a security that is specific to that investment and unrelated to the overall risk of the market .
  • CAPM states that in market equilibrium, investors are only rewarded for bearing systematic risk - the type of risk that cannot be diversified away.
  • The expected rate of return = the rate of return for a risk-free asset + beta* (the rate of return of the market - the risk-free rate).
  • The return of the market minus the risk-free rate is also known as the risk premium.

• Defining the Security Market Line

  • The security market line displays the expected rate of return of a security as a function of systematic, non-diversifiable risk.
  • The security market line graphs the systematic, non-diversifiable risk (stated in terms of beta) versus the return of the whole market at a particular time, and shows all risky marketable securities.
  • When used in portfolio management, the SML represents the investment's opportunity cost -- i.e., investing in a combination of the market portfolio and the risk-free asset.
  • The slope of the SML is equal to the market risk premium and reflects the risk return trade off at a given time.
  • The y-intercept of this line is the risk-free rate (the ROI of an investment with beta value of 0), and the slope is the premium that the market charges for risk.

• Commercial Banks

  • Risk management (i.e. foreign exchange risks, interest rates, hedging commodities, derivatives)
  • Credit Risk – Risk that a borrower may not return the entirety of the payment owed.
  • Liquidity Risk – Risk that an acquired asset cannot be traded quickly enough to capture profit.
  • Market Risk – Virtually any capital asset has a market, and is therefore subjected to the risks of it's respective market.
  • Operational Risk – Risk that an operational issue will diminish returns.

• Impact of Diversification on Risk and Return: Systematic Risk

  • Systematic risk is intrinsic to the market, and thusly diversification has no effect on its presence in investments.
  • Recall that previously we talked about the security market line and the implication that investors require more compensation for extra risk.
  • This is the principle behind the security market line .
  • Now, imagine that these 50 corporations are all given a lesser credit rating because of the risk of their overall market segment.
  • This is the portion of risk that pays the risk premium, because the risk associated with this particular segment of the market is more tightly linked to the risk of the market as a whole.

• Approaches to Assessing Risk

  • Since planned actions are subject to large cost and benefit risks, proper risk assessment and risk management for such actions are crucial to making them successful.
  • As risk carries so many different meanings, there are many formal methods used to assess or to "measure" risk.
  • Its impact can be on the very existence, the resources (human and capital), the products and services, or the customers of the enterprise, as well as external impacts on society, markets, or the environment.
  • In a financial institution, enterprise risk management is normally thought of as the combination of credit risk, interest rate risk or asset liability management, market risk, and operational risk.
  • In project management, risk management can include: planning how risk will be managed, assigning a risk officer, maintaining a database of live risks, and preparing risk mitigation plans.

• Expected Risk and Risk Premium

  • Overall riskiness of an asset is composed of its own individual risk (beta) along with its risk in relation to the market as a whole.
  • Systemic risk is the risk associated with an entire financial system or entire market.
  • This type of risk is inherent in all marketable securities and cannot be diversified away.
  • This type of risk is uncorrelated with broad market returns, and with proper grouping of assets can be reduced or even eliminated.
  • This is a number describing the correlated volatility of an asset in relation to the volatility of the benchmark that said asset is being compared to -- usually the market as expressed in an index.

• Default Risk and Bond Price

  • Supply and demand functions that you already learned in the last chapter can help explain the impact of risk of a market.
  • We draw the supply and demand for two markets: government bond market and corporate bond market.
  • We set the same equilibrium price and quantity for both markets in Figure 1, which means both markets have identical risks.
  • As the default risk increases, then the risk premium increases too.
  • Impact of a risk premium on the bond markets

• Comparing Price Risk and Reinvestment Risk

  • Price risk and reinvestment risk both represent the uncertainty associated with the effects of changes in market interest rates.
  • Bond market prices will decrease in value when the generally prevailing interest rates rise (price risk is on the rise).
  • Since the payments are fixed, a decrease in the market price of the bond means an increase in its yield.
  • When the market interest rate rises, the market price of bonds will fall, reflecting investors' ability to get a higher interest rate on their money elsewhere — perhaps by purchasing a newly issued bond that already features the newly higher interest rate.
  • In summary, price risk and reinvestment risk are two main financial risks resulting from changes in interest rates.