Market risk is that type of risk, which mentions that the value of an invested amount will go down because of movements or variations in market elements.
The standardized market risk elements can be categorized into the following types :
Interest rate risk: This type of risk assumes that interest rates will vary
Equity risk: This is a risk that states stock prices will vary
Commodity risk: This risk mentions that commodity prices (for example, metals, food grains, and others) will deviate
Currency risk: This risk states that foreign exchange rates will deviate
In some instances, a fifth market risk element is also taken into consideration and that is as follows:
Equity index risk: This type of market risk states that the stock index prices or other index prices would vary.
Measurement of Market Risk
Usually, market risk is measured with the help of Value at Risk technique. The value at risk method has been widely acclaimed as a form of risk management method. However, it includes some restricting presumptions that limit its exactitude. The first presumption is that the formation of the portfolio that has been assessed stays unaltered in a single term of the model. In case of short-term scenario, this restricting presumption is frequently considered as satisfactory. In case of long term scenario, a large number of transactions in that portfolio may meet the maturity period in the duration of the model term period. The factors that are usually ignored in this type of modeling pattern (single period) are embedded options, movements in variable rates of interest, interfering cash flow and many others.
The market risk has the opposite features of specific risk. In case of specific risk, the measurement of a decline in the value of investment is carried out, which happens as a result of any modification in a particular sector or industry in opposition to a market-wide change.
In the United States of America, the SEC or Securities Exchange Commission has prescribed a section on market risk that should be documented in every annual report presented on Form 10-K. The company concerned has to provide the detailed information about how its financial performances are dependent on the financial markets actively. This has been planned to reveal, for instance, that an investor who assumes that he is going to invest in a milk company, however, in reality the company is involved in performing non-dairy operations, for example, investment in forex futures or complex derivatives.
Every business takes risk on the basis of two elements, one is the chance that some adverse financial situation will occur and the second is the cost related to that adverse financial condition.
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Last Updated on : 1st July 2013