LEVEL: BEGINNER
Market risks are risks associated with movements from market prices. Market prices include changes in equity, commodity, interest rate, or even currency rates. Market risks are sometimes difficult to measure as a portfolio of financial instruments can be subject to transparent market movements or changes in value due to opaque risks. The measurement of market risk can come in many formats which include the percent change of a financial instrument to the value at risk of a portfolio. Management techniques to mitigate market risk are a key element for investors in trading a successful portfolio.
Equity Risk
Equities refer to stocks, which are publicly traded companies that raise money by issuing ownership to the public in the form of common or preferred stocks. Common stocks make of the majority of equity risk, which is expressed in the form of stock price volatility. Stock prices can be very volatile, with historical volatility on individual stock as high as 50% on an annualized basis. Exposure to this type of volatility can lead to outsized gains and extreme losses.
In an effort to mitigate equity risk, investors will diversify their portfolios, choosing multiple stock sectors which will generate balanced returns in both up and down market conditions. Investors can also mitigate equity risk by hedging using a number of derivative products such as options and short sales.
Short Sale
A short sale on equities is a transaction in which an investor borrows capital and uses that capital to sell a stock hoping the stock moves lower and can be re-purchased for a profit. Prior to selling the stock, the investor needs to insure that their broker can lend against the short sale of the stock otherwise a sale will be considered a naked short sale. A short sale of a stock can be used to hedge a portfolio without generating a sale from a current portfolio position and creating tax implications.
Options
A put option on a stock is the write but not the obligation to sell a stock at a specific price on or before a certain date. The price at which the buyer and seller of a put option agree to exchange the stock is called the strike price while the date at which the option will expire is referred to as the expiration date. Put options that give an investor the right to exercise at any point prior to expiration are called American style options, and option that only allow an investor to exercise the option on the expiration date are called European style options. A put option will mitigate the risk that an equity portfolio will move down in price.
Interest Rate Risk
Interest rate risk for most investors is exposure to fluctuating prices in fixed income production in which the price of the instrument moves lower. Price and yields on interest rate products such as bonds move in opposite directions. When the price of a bond moves higher, the yield on that bond moves lower. When the price of a bond moves lower, the yield on the bond moves higher. Fixed income products fluctuate based on market sentiment, similar to stocks and commodities. As a general rule of thumb, when economic growth is expanding, short term interest rates are moving higher as investors are preparing for the Federal Reserve to increase borrowing rates, to moderate inflation. The reverse generalization is also true. As economic performance in a country is receding, short term interest rates are falling as investors are preparing for the Federal Reserve to lower interest rates to stimulate growth.
While short term interest rates are closely tied to Federal Reserve action, long term interest rates are more of a function of market influences.
Investors can mitigate interest rates risks by creating a diversified portfolio of interest rate products in terms of the borrower, as well as, the duration. Borrowers are sovereigns, municipalities, as well as corporates. Sovereigns generally have the lowest borrowing costs while corporates usually have the highest borrowing costs. In terms of tenors, short term interest rate products are usually less volatile than longer term fixed income securities.
Commodities
Commodity market risk is exposure to products that are considered hard assets and are fungible across all delivery points. For example, light sweet crude oil delivered in Cushing Oklahoma is the same as light sweet crude delivered in Amsterdam.
Commodities are volatile assets that tend to move higher during times of strong economic growth, and tend to decline during periods of economic contraction. Commodities are viewed as a hedge against future inflation, and are used by many as a separate asset class which are uncorrelated with the movements of stocks and bonds.
Most investors can attain commodity exposure by purchasing or selling futures contracts or investing in commodity exchange traded funds. A futures contract is the obligation to purchase a physical commodity at some period in the future. Futures contracts are available through a futures broker, who will facilitate the process of trading through a regulated futures exchange.
Commodity ETF does can hold a basket of futures and physical commodities which will provide access to commodity risk.
Currencies
Many investors view the currency markets, also known as the foreign exchange markets, as a separate asset class. The currency markets provide investors with exposure to one currency relative to another currency. The security that is traded within the FOREX markets is known as a currency pair, which consists of two currencies.
Currency risk can be initiated by an investor to gain exposure to this vast capital market, or be a by-product of securities that are backed by a different currency than an investor’s home currency. For example, if an investor owned German Bunds, they would own exposure to fixed income bonds that are issued in Euros.
Value at Risk
Value at risk is one of the more popular ways investors measure risk. Value at risk evaluates a specific standard deviation move, and the losses associated with that type of move. Value at risk uses either historical data or a simulation to determine the potential loss that can come from a large move in assets that are within a portfolio. Measuring risk in this fashion has pros and cons, but ultimately it is an effective way to measure risk.