Market Risk

Market risk is the risk of losing money because of movements in market prices: share prices, interest rates, exchange rates and commodity prices. It affects almost every investment at the same time, because it comes from forces such as recessions, central-bank decisions, wars and shifts in investor mood rather than from problems at one company. For this reason it is also called systematic or undiversifiable risk. It is one category of risk in finance, the broader idea that actual outcomes may differ from what was expected, alongside credit, liquidity and operational risk.

The term is used in two related settings. Investors use it to describe the part of a portfolio's ups and downs that holding more securities cannot remove. Banks and their supervisors use it as one of the three main risk categories, alongside credit risk and operational risk, and must hold capital against it under rules set by the Basel Committee on Banking Supervision.

Think of boats in a harbour. Each boat can have its own problem, a leak or a broken engine, and owning many boats protects you from any single one sinking. But when the tide goes out, every boat drops together, however many you own. Market risk is the tide.

A shopkeeper who owns shares in fifty different companies has largely protected herself from one company going bust. She has not protected herself from a crash that pulls down all fifty at once. The only ways to reduce that are to hold less in the market, to hold different kinds of assets, or to buy insurance-like contracts that pay out when prices fall.

Modern portfolio theory splits an investment's total risk into two parts. Unsystematic (specific) risk belongs to one company or sector and can be largely removed through diversification. Systematic risk, the market risk, remains. Because it cannot be diversified away, it is the risk investors expect to be paid for, which is the basis of the risk–return trade-off.

A stock's exposure to market risk is measured by its beta: a beta of 1.2 means the stock has historically moved about 20% more than the market. Total price swings are measured by volatility, usually expressed as the standard deviation of returns. A long bear market or the 2008 financial crisis shows market risk at its starkest, when correlations between assets rise and diversification helps less than expected.

• Equity risk. The risk that share prices or stock indices fall.
• Interest rate risk. The risk that changing rates reduce the value of bonds and other fixed-income holdings; see interest rate risk.
• Currency risk. The risk that foreign exchange moves reduce the home-currency value of foreign assets or income.
• Commodity risk. The risk of losses from price changes in oil, metals, grains and other goods traded on the commodities market.

The most widely used single figure is value at risk (VaR): the loss that a portfolio should not exceed over a set period at a chosen confidence level. A simple parametric version assumes normally distributed returns:

• $z$ is the number of standard deviations for the confidence level (about 2.33 for 99%).
• $\sigma$ is the daily standard deviation of returns.
• $V$ is the value of the portfolio.
• $t$ is the holding period in days.

For a portfolio worth 10 million with a daily standard deviation of 1%, one-day 99% VaR is $2.33 \times 0.01 \times 10{,}000{,}000 = 233{,}000$. On roughly 99 days out of 100 the loss should be smaller than 233,000. VaR says nothing about how large losses are on the remaining day, which is why it is paired with stress tests and, in bank regulation, with expected shortfall, the average loss beyond the VaR threshold. Banks also mark positions to market daily so that these measures reflect current prices. Such models assume the odds of each outcome can be measured; events whose probabilities cannot be estimated at all fall under Knightian uncertainty.

The Basel Committee added market risk to its capital rules with the 1996 Market Risk Amendment, which let large banks use internal VaR models for their trading positions. After losses in the 2007–2009 crisis, "Basel 2.5" (2009) added a stressed VaR charge. The Fundamental Review of the Trading Book, published in January 2016 and revised in January 2019 as part of Basel III, replaced VaR with expected shortfall at a 97.5% confidence level, tightened the boundary between the trading book and the banking book, and revised the standardised approach. Implementation has been phased and delayed in several jurisdictions.

Banks and investors manage market risk by limiting position sizes, matching assets and liabilities, and hedging with derivatives such as futures, swaps and options. Individual investors manage it mainly through asset allocation in line with their risk tolerance and time horizon.

• Minimum capital requirements for market risk (January 2019) — Basel Committee on Banking Supervision