How does market risk work?

Market risk is defined as the risk of losses arising from movements in market prices. It is essentially a very simple concept, depending on which side of a transaction we are on (or expect to be on in the future). For example, if a firm takes a long (buy) position on a goods, stock, commodity or investment asset, the market risk exposure can be defined by how much can be lost if there is a fall in market price for this stock over a holding period. By contrast, if a firm needs to buy a commodity or asset, in market risk terms they have a ‘short’ exposure to the price. That is if the price goes up, they will incur greater costs and ‘lose’ on the price rise.

The preceding discussion leads us to ask questions such as

• What level of risk is tolerable?
• Given this level of risk, what amounts should be traded?
• How should I manage (hedge) the risk exposure

Managing market risk

The use of derivative contracts for hedging is one way of dealing with managing market risk. There are other techniques such as maturity matching and immunisation in interest rate markets as a couple of examples, but an explanation of these would be quite complicated to cover in this article.

If we reflect on our example of the rice farmer in step 3.9, the rice farmer has a ‘long’ exposure to the price of a tonne of rice in the future when the harvest is brought to market, while on the other side the sushi restaurant has a ‘short’ exposure because they need to buy rice. With regard to the questions above, by fully covering the long rice position with a futures contract the farmer’s answer to the first question above is ‘none’, and by fully covering the position with an offsetting futures position we can infer that the farmer has a high degree of uncertainty about the future spot price of rice or is certain that the price will fall. If, on the other hand, our farmer was certain that the price of rice was going to rise, then ‘all’ or ‘some’ might be their answers to the first two questions and they might choose to leave their long position fully exposed to the market or partially cover the exposure with a futures contract.

Market risk occurs in any market where prices move up and down according to supply and demand conditions and the actions of market traders.

Volatility

When we think about price movements we need to think beyond the (simple) consideration of whether prices move up or down – we also think about the volatility of the price – that is how much prices move and how fast or how often they move. A commodity or stock with a price that fluctuates wildly—hits new highs and lows or moves erratically—is considered highly volatile. A stock that maintains a relatively stable price has low volatility. That is not so say that high or low volatility are neither good nor bad, rather that we need to be aware of the level of volatility and take it into account when determining our tolerance for market risk and our approach for managing it. Market risk (price uncertainty) is naturally higher in more volatile markets.

Leverage

The concept of leverage is another important consideration when thinking about market risk. It is possible to amplify market risk using leverage – either by borrowing funds to take a position or by using certain types of derivatives like options and futures.

To illustrate – consider an investor that has $10,000 to invest in a stock that typically moves 5 to 15% in a year, and then decides to ‘leverage’ or ‘gear up’ their returns by using 2 times leverage (that is by borrowing another $20,000 from someone else) to take a larger effective position in the stock. If the stock goes up by 15%, $4500, the investor closes the position out, repays the loan and is left with a gain of $4500 (ignoring for the moment transaction costs, loan interest and taxes) a 45% gross return on the investor’s own funds instead of the 15% gain they would have earned on an unleveraged position on the stock. Conversely, if the investor had leveraged and the stock fell by 15%, a 45% loss would have resulted, compared to a 15% loss on an unleveraged position. Like volatility, leverage can be exploited to amplify gains, but with that it amplifies market risk and should be used with due care.