In investment risk, there are two major categories such as market risk and specific risk and under these categories are different classifications that involve unique aspects of financial markets. This article will focus on market risk and its types.
WHAT IS MARKET RISK?
Market risk is the possibility for an investor to face losses due to factors that affect the overall performance of the financial markets in which he/she is involved. Market risk, also called “systematic risk,” cannot be eliminated through diversification, though it can be hedged against. Sources of market risk include recessions, political turmoil, changes in interest rates, natural disasters and terrorist attacks.
Market risk is comprised of the “unknown unknowns” that occur as a result of everyday life. It is inevitable in all risky investments. It can also be thought of as the
opportunity cost of putting money at risk.
TYPES OF MARKET RISKS
The most common types of market risks include interest rate risk, equity risk, currency risk, commodity risk, and inflation risk.
Currency risk is one of the types of market risks that exchange rates will go up or possibly down. An investor is exposed to currency risk if he is holding particular currencies facing volatile movements, because of fundamental factors such as interest rate changes or unemployment claims.
Equity risk is one of the types of market risks wherein the prices will change, particularly in stock prices. In many cases, stocks have higher associated risks than other investment classes such as government bonds. Some types of equities such as small-cap stocks traded on emerging markets can be extremely unstable.
Inflation risk is the risk where overall rises in prices of goods and services. The potential for inflation to increase the price of all goods and services such that it undermines the value of money and probably badly impacts the value of investments.
Commodity risk covers the changing prices of commodities such as crude oil and corn. The prices of commodities can be volatile in the short term and they can also follow long cycles, meaning that prices can stay elevated or depressed for extended periods of time. As a result, commodity price volatility is a key risk to industries that directly produce commodities, or that use them as an input.
Read about Benefits of Commodity Investments
Interest Rate Risk
Interest rate risk is the risk that the value of a security will fall as a result of an increase in interest rates. This risk covers the volatility that happens with changing interest rates due to fundamental factors. The risk of unpredictable interest rate changes and the prices of most assets are sensitive to changes in interest rates.
The majority of investors knows that investing comes with risks as well as rewards, and that, overall, the greater the risk, the bigger the potential reward. Risk can be reduced to some extent if you diversify your investments such as widening your portfolio. However, it is impossible to eliminate all risks.
While it is vital to consider the risks in the context of a specific market or investment class, it is also just as important to consider market risk.
See also Why is Risk Tolerance Important?
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