Market risk and how to hedge Market risk and how to hedge Market risk and how to hedge

Market risk and how to hedge

Trading Strategies

Saxo Group

Before we explain the fundamentals of market risk, it’s worth defining what a financial market is. The simple definition of a financial market is a place where things are bought and sold. These “things” can be anything with value. In the financial sector specifically, we use “securities” or “financial instruments” as broad terms for things that have a tradable value. 

For example, the stock market is a place where people can buy and sell shares in companies like Apple and Tesla. The forex market is where currency pairs are traded. There are other types of financial markets, including equities, commodities and bonds. We don’t need to explain them all, other than to reiterate the point that markets are where a type of security is traded. 

Financial markets have an inherent value. They’re made up of securities and these securities have a certain amount of value in their own right. So, if we go back to our stock market example, Apple has its own value. This gives the stock market a certain inherent value. 

However, what’s also important to understand about financial markets is that outside factors can affect their value. Trading activity, politics, economics and major global events can all impact the financial markets and, therefore, the securities within them. This is where market risk comes in. 

What is market risk in trading? 

Market risk is a risk that affects the market as a whole and it is considered a more general risk. So, let’s say interest rates skyrocket. That could affect the stock market in general. Because of this, it will affect the price of Apple shares, Tesla shares and all stocks in the market. Therefore, it’s a general risk that affects the entire market and not a specific risk that only affects one asset. 

On the other hand, if for example Apple publishes a poor quarterly return, that could negatively affect Apple shares, especially if it was unexpected. The Apple quarterly report probably won’t affect the price of Tesla shares. Therefore, we can refer to the quarterly report as an individual or specific risk. 

The last thing to note is that market risk is often unfavourable and unpredictable. You might measure market risk and take steps to mitigate it. However, usually the risks are beyond your control. 

For example, if a major political event happens in a foreign country, that’s likely to affect the financial markets. Of course it’s usually impossible see something like that coming and there’s not a lot you can do when it happens. However, you can ensure you have a diversified portfolio so you are better prepared for market volatility, for example, when unpredictable global events happen. Otherwise, you simply have to accept that market risk is an inevitable part of trading. 

Four types of market risk in trading 

There are four types of market risk: 

Interest rate risk 

A sudden change to interest rates can impact the financial markets. When interest rates increase suddenly and/or dramatically, people spend less and save more. When interest rates fall sharply, people tend to spend more and save less. This dynamic affects a variety of markets. 

For example, if interest rates are high and people aren’t spending as much, there will be fewer people purchasing consumables, which hurts stock prices. People may also travel less, which means oil prices could suffer. A drop in spending can also affect currency markets. 

Taking this a step further, high-interest rates may deter businesses from borrowing money from banks. A company could also reduce spending. Then there’s the risk of higher interest rates causing the national currency to appreciate. This could attract more foreign investment because of the strong currency. The consequence of more foreign capital coming into the country is a reduction in export power for local companies. 

The reverse can be true when interest rates fall. However, the main point here is that significant changes to interest rates, either increases or decreases, can cause volatility within the financial markets. So, as you can see, from something as seemingly simple as a change in interest rates, a complex series of interlinked events can occur. It’s these events that will affect the financial markets. 

Exchange rate risk 

Fluctuating currency prices can also cause market volatility which creates risk. When the value of a currency changes, it affects the purchasing power of the associated country. This is because currencies are linked through exchange economics. Simply put, when one currency strengthens, another has to weaken and vice versa. 

So, when USD is strong against GBP, it means the latter has weakened in relation to the former. You need more GBP to buy 1 USD. Or, if you look at it from the other perspective, you need less USD to buy 1 GBP. 

These fluctuations can affect countries and businesses. For example, if a UK company exports products to the US, a strong GBP isn’t ideal. Why? Because US consumers pay in USD. And, as we’ve said, a strong GBP means you need more USD to buy one unit of GBP. Thus, products shipped from the UK become more expensive for consumers in the US. 

Naturally, the opposite is true. Consumers in the UK get a better deal on US products when GBP is strong. Exchange rates can affect financial markets because of the impact they have on purchasing power. Forex trading (i.e. the currency trading market) is obviously at risk from major changes to exchange rates. Stock markets are also at risk because of foreign trade. Commodity markets can also be affected when the commodities are priced in a foreign currency. 

Equity price risk 
Equity price risk is when the value of a security changes quickly. This type of market risk generally focuses on the stock market. Although the price of stocks can be affected by a variety of factors, there are two overarching categories of risk: systematic and unsystematic. 

Systematic risk 
Systematic risk refers to an industry or sector. For example, if you owned shares in Apple and a crisis hit the tech industry or the mobile phone sector, it would impact your holding. The crisis would also impact the sector. 

Unsystematic risk 

Unsystematic risk refers to a specific company. For example, if the CEO of Apple was fired for misconduct, it could hurt the company's value. Unsystematic risk is, therefore, not related to the “system” but to individual companies. However, it’s still a market risk you have to consider in tandem with general (i.e. systematic) risk. 

Commodity price risk 

The changing value of major commodities like gold, corn and crude oil can impact a variety of financial markets. These fluctuations are often linked to political, seasonal, or regulatory changes. However, these aren’t the only reasons. 

Consider the price of crude oil in recent years. Following global health concerns and climate change protests, the price of oil has become volatile. So, what we can say here is that any major event that impacts daily life, such as travel restrictions, can affect the price of commodities. 

Commodity price risk will clearly affect investments in gold, oil, corn, etc. However, these fluctuations can also affect other markets. For example, if fuel prices are high, haulage companies and airlines can be affected. Supply chains can also be affected. 

So, again, what we can see here is that changes in one area can impact a variety of seemingly unrelated financial markets. We say seemingly because, while they might not appear to be connected at first glance, market risks show us that, in at least some way, all financial markets are connected. 

How to measure market risk 

Now we’ve defined market risk and the four areas to consider, the last thing to look at is measurement. How do we measure market risk? There are two key measures of market risk: 

Beta: This market risk measurement looks at the previous performance of stock and compares it to the market as a whole. This provides an insight into how volatile the stock is and whether it’s moving in line with the market. 

Value-at-Risk (VaR): This market risk measurement is a statistical method that assesses the potential loss over a period of time. This calculation considers the size of a potential loss, the probability a loss will occur and the time in which it might happen. When put into a VaR calculation, these variables give you a percentage chance of how much a security/portfolio/market might decline in value. 

Although Beta and VaR can measure market risk, they’re not infallible. You may need to use them in tandem. You may not use them at all because the event was unexpected or beyond your control. So, while measuring market risk is important, it’s not an exact science. You can’t eliminate market risk. It’s something that will always be there, which means you have to factor in its potential effects and accept any negative swings when they occur. 

Risk management strategies 

Diversification is a common risk management tool used in trading. To have a diverse portfolio means you have investments in a variety of financial instruments. For example, you might have stocks in two companies, a forex holding and oil shares. The theory here is that, by having a diversified portfolio, you’re able to even out risk. So, when forex is struggling, for example, the rest of your portfolio could be bullish. Therefore, the downswing for forex isn’t as significant to your bottom line. 

This strategy doesn’t work regarding market risk because the issues are more widespread. When interest rate risk hurts one sector, it may also negatively impact other sectors. So, it’s a general problem that can affect a variety of markets and, therefore, financial instruments. This means having a stake in stocks, forex and oil doesn’t really matter. If one is hurting, the market risk is that they could all be hurting.  

Hedging against market risk 

If diversification can’t help you mitigate market risk, what can you do? It’s almost impossible to counter market risk but hedging can offer some protection. 

This trading strategy won’t eliminate risk, but it can help to reduce negative swings. In summary, hedging is where you hold two or more simultaneous positions. The aim here is to offset losses in one area with gains in another. 

For example, in forex trading, you might have a long position on USD/GBP. However, to help hedge against currency price risk, you decide to take out a short position. This means you’re buying and selling the same currency pair simultaneously. That also means you’ll make money if the currency appreciates or depreciates in value. 

Naturally, the gains will be reduced or cancelled out by the losses and vice versa. However, what you’re doing in this scenario is taking out two positions to cover your bases. So, if something happens, you’re able to protect against swings in either direction. What’s important to understand, however, is that you shouldn’t hedge for long periods. 

Hedging is usually seen as a short-term strategy because it can eat into your profit. This means you’ll hedge positions when market risk or the potential for market risk is high and stop once volatility decreases. It’s hard to time these things perfectly, and hedging won’t eliminate market risk. But it is a tool you can use to reduce risk. 

Understanding and accepting risk is an important part of trading. Reducing the impact of risk is also important, but the point you should take from this guide is that market risk will always be there. 

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