Types of Market Risk

There are four major types of market risk:

  • Interest Rate Risk
  • Equity Price Risk
  • Foreign Exchange Risk
  • Commodity Price Risk

Interest Rate Risk

Interest rate risk is the risk that the value of a security will fall as a result of increase in interest rates. However, in complex portfolios, many different types of exposures can arise.

Basis risk: Banks can face basis risk if the interest-bearing assets and liabilities have different bases such as the London Interbank Offered Rate (LIBOR) versus the U.S. prime rate. In some circumstances different bases will move at different rates or in different directions, which can cause erratic changes in revenues and expenses.

Repricing risk: Banks can also face repricing risk, that is, the risk presented by assets and liabilities that reprice at different times and rates. For instance, a loan with a variable rate will generate more interest income when rates rise and less interest income when rates fall. If the loan is funded with fixed rated deposits, the bank's interest margin will fluctuate.

Yield curve risk: Yield curve risk is presented by differences between short-term and long-term interest rates.

Under normal circumstances, the short-term rates are lower than long-term rates, and banks earn profits by borrowing short-term money and investing in long-term assets. However, any change in the yield curve can dramatically affect bank’s earnings.

Options risk: The optionality embedded in some assets and liabilities gives rise to options risk. This can be seen in the prepayment speeds of the mortgage loans, with changing interest rates. Falling interest rates will cause many borrowers to refinance and repay their loans, leaving the bank with uninvested cash when interest rates have declined. Alternately, rising interest rates cause mortgage borrowers to repay slower, leaving the bank with more loans based on prior, lower interest rates. Option risk is difficult to measure and control.

Equity Price Risk

Equity price risk refers to the risk arising from the volatility in the stock prices.

While talking about equity risk, it is important to differentiate between systematic risk and unsystematic risk.

Systematic risk refers to the risk due to general market factors and affects the entire industry. It cannot be diversified away.

Unsystematic risk is the risk specific to a company that arises due to the company specific characteristics. According to portfolio theory, this risk can be eliminated through diversification.

Foreign Exchange Risk

Foreign exchange risk arises because of the fluctuations in the currency exchange rates.

Companies may be exposed to the foreign exchange risk in their normal course of business because of the unhedged positions or because on imperfect hedges.

Commodity Price Risk

Commodity Price Risk refers to the risk of unexpected changes in a commodity price, such as the price of oil.

These commodities may be grains, metals, gas, electricity etc.

Commodity risk affects various sections of people:

  • Producers (Farmers, plantation companies, and mining companies)
  • Buyers (Cooperatives, commercial traders, etc)
  • Exporters
  • Governments