Market risk and how to hedge

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 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. 

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.