“MARKET RISK”

(part 1)
Dr. Luis R. Alamil, CPA, FFA-Aus., Ph.DBA
Course facilitator
 Market risk
• The risk of losses on financial investments
caused by adverse price movements.
• May arise due to changes of:
1. interest rates,
2. exchange rates,
3. geopolitical events, or
4. Economic condition (recessions).
 Market risk (or systematic risk)
• Affects the performance of the entire market
simultaneously. Cannot be eliminated through
diversification.
• In contrast to specific risk, or unsystematic risk
which involves the performance of a particular
security and can be mitigated through
diversification.
 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:
o recessions,
o political turmoil,
o changes in interest rates,
o natural disasters, and
o terrorist attacks.
• Systematic risk, or market risk, tends to influence the entire
market at the same time.
 Understanding Market Risk
• Market risk can be contrasted with
unsystematic risk, which is unique to a specific
company or industry.
• Unsystematic risk is 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.
 Understanding Market Risk
• 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%.
 Understanding Market Risk
• 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.
• 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.
Most common types of market risks
• 1. 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.
Most common types of market risks
• 2. Equity risk is the risk involved in the
changing prices of stock investments.
• 3. Commodity risk covers the changing prices
of commodities such as crude oil, corn, wheat,
etc.
• 4. 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.
 Managing Market Risk
• If you are investing, there is no single way to
completely avoid market risk.
• However, you can use hedging strategies to
protect against volatility and minimize the impact
that market risk will have on your investments
and overall financial health.
o For example, you can buy put options to protect
against a downside move when targeting specific
securities.
o Or, if you want to hedge a large portfolio of stocks,
you can utilize index options.
 Hedging Strategy
• Hedging is a risk management strategy
employed to offset losses in investments by
taking an opposite position in a related asset.
• The reduction in risk provided by hedging also
typically results in a reduction in potential
profits.
 What Is Hedging?
• The best way to understand hedging is to think of it as a
form of insurance.
• When people decide to hedge, they are insuring
themselves against a negative event's impact on their
finances. This doesn't prevent all negative events from
happening. However, if a negative event does happen and
you're properly hedged, the impact of the event is
reduced.
• In practice, hedging occurs almost everywhere. For
example, if you buy homeowner's insurance, you are
hedging yourself against fires, break-ins, or other
unforeseen disasters.
 What Is Hedging?
• Portfolio managers, individual investors, and
corporations use hedging techniques to
reduce their exposure to various risks.
• In financial markets, however, hedging is not
as simple as paying an insurance company a
fee every year for coverage.
 What Is Hedging?
• Hedging against investment risk means
strategically using financial instruments or
market strategies to offset the risk of any
adverse price movements.
• Put another way, investors hedge one
investment by making a trade in another.
 Understanding Hedging
• Hedging techniques generally involve the use of
financial instruments known as derivatives. Two
of the most common derivatives are options
and futures. With derivatives, you can develop
trading strategies where a loss in one
investment is offset by a gain in a derivative.
 What Are Derivatives?
• Derivatives are securities whose value is
dependent on or derived from an underlying
asset.
• For example, an oil futures contract is a type of
derivative whose value is based on the market
price of oil.
• Derivatives have become increasingly popular in
recent decades, with the
total value of derivatives outstanding was
estimated at $610 trillion at June 30, 2021.
 Understanding Hedging
• Suppose you own shares of Cory's Tequila Corporation
(ticker: CTC). Although you believe in the company for
the long run, you are worried about some short-term
losses in the tequila industry.
• To protect yourself from a fall in CTC, you can buy a
put option on the company, which gives you the right
to sell CTC at a specific price (also called the strike
price).
• This strategy is known as a married put. If your stock
price tumbles below the strike price, these losses will
be offset by gains in the put option.
 Understanding Hedging
• Another classic hedging example involves a
company that depends on a certain
commodity.
• Suppose that Cory's Tequila Corporation is
worried about the volatility in the price of
agave (the plant used to make tequila). The
company would be in deep trouble if the price
of agave were to skyrocket because this would
severely impact their profits.
 Understanding Hedging
• If the agave skyrockets above the price specified by the
futures contract, this hedging strategy will have paid off
because CTC will save money by paying the lower price.
• However, if the price goes down, CTC is still obligated to
pay the price in the contract. And, therefore, they
would have been better off not hedging against this
risk.
• Because there are so many different types of options
and futures contracts, an investor can hedge against
nearly anything, including stocks, commodities, interest
rates, or currencies.
 Managing Market Risk
• If you are investing, there is no single way to
completely avoid market risk. But you can use
hedging strategies to protect against volatility and
minimize the impact that market risk will have on
your investments and overall financial health.
• For example, you can buy put options to protect
against a downside move when targeting specific
securities. Or, if you want to hedge a large
portfolio of stocks, you can utilize index options.
 Managing Market Risk
• Use a variety of these strategies to manage
market risk and protect your portfolio.
• Dollar-cost averaging won’t protect you
against market risk. But investing the same
amount of money on a regular schedule can
help you ride out ups and downs in the
market, taking advantage of periods of both
low costs and high returns.
 Managing Market Risk
• Use a variety of these strategies to manage market risk
and protect your portfolio.
• 1. Study Currency Profiles
• If you are investing in foreign markets, pay attention to
the currency profiles of the companies in which you
invest.
• Industries that import more, for example, will be
impacted by changes to the local currency. Industries
that export more will be affected by changes to the
value of the euro or dollar. Allocate your assets across a
variety of industries to mitigate risk, and invest in
markets and companies backed by strong currencies.
 Managing Market Risk
• 2. Watch Interest Rates
• To manage interest rate risk, pay attention to
monetary policy and be prepared to shift your
investments to account for interest rate
changes.
• For example, if you are heavily invested in
bonds and interest rates are rising, you may
want to tweak your investments to focus on
shorter-term bonds.
 Managing Market Risk
• 3. Maintain Liquidity
• When markets are volatile, you may have trouble
selling or buying an asset within your price range,
especially when you need to exit a position in a
hurry.
• If the market is crashing, liquidity may be difficult
no matter what type of stocks you buy. Under
more normal conditions, though, you can maintain
your liquidity by sticking with stocks that have low
impact cost (the cost of a transaction for that
stock) to make trading easier.
 Managing Market Risk
• 4. Invest in Staples
• Some industries tend to do well even when the
overall economy is poor. These tend to be utilities
and businesses producing consumer staples.
That’s because no matter what the economy is
doing, people still need to turn their lights on, still
need to eat, and still need toilet paper and
toothpaste.
• By keeping some of your money in staples, you
can still see returns in a recession or a period of
high unemployment.
 Managing Market Risk
• 5. Think Long Term
• No matter where you invest your money, it is
impossible to fully escape market risk and
volatility. But you can manage this risk, and
escape much of the impact of volatile
markets, by using a long-term investing
strategy.
 Managing Market Risk
• 5. Think Long Term
• You may want to make small tweaks in response to
changes in the market. But don’t upend your entire
investing strategy because a recession hit or a
currency changed value.
• In general, short-term traders are more impacted by
volatility. By contrast, over time, volatility tends to
even out over time. By approaching your investing
systematically, and sticking with a long-term outlook
and strategy, you are more likely to see your portfolio
bounce back from the impact of market risks.
 Part 2
Measuring Market Risk