Business, Legal & Accounting Glossary
Exposure to the uncertain market value of a portfolio. Risk which is common to an entire class of assets or liabilities. The value of investments may decline over a given time period simply because of economic changes or other events that impact large portions of the market. Asset allocation and diversification can protect against market risk because different portions of the market tend to underperform at different times.
Market Risk is exposure to the uncertain market value of a portfolio. Market risk is managed with a short-term focus, unlike business risk which is managed with a long term goal. Conventionally, the best way to measure market risk is using a Value at Risk calculation. The four standard market risk factors are Equity Risk, Interest Rate Risk, Currency Risk, and Commodity Risk.
Business activities entail a variety of risks. For convenience, we distinguish between different categories of risk: market risk, credit risk, liquidity risk, etc.
Although such categorization is convenient, it is only informal. Usage and definitions vary. Boundaries between categories are blurred. A loss due to widening credit spreads may reasonably be called a market loss or a credit loss, so market risk and credit risk overlap. Liquidity risk compounds other risks, such as market risk and credit risk. It cannot be divorced from the risks it compounds.
An important but somewhat ambiguous distinguish is that between market risk and business risk. Market risk is exposure to the uncertain market value of a portfolio. A trader holds a portfolio of commodity forwards. She knows what its market value is today, but she is uncertain as to its market value a week from today. She faces market risk. Business risk is exposure to uncertainty in economic value that cannot be marked to market. The distinction between market risk and business risk parallels the distinction between mark-to-market accounting and book-value accounting.
Suppose a New England electricity wholesaler is long a forward contract for on-peak electricity delivered over the next 3 months. There is an active forward market for such electricity, so the contract can be marked to market daily. Daily profits and losses on the contract reflect market risk. Suppose the firm also owns a power plant with an expected useful life of 30 years. Power plants change hands infrequently, and electricity forward curves don’t exist out to 30 years. The plant cannot be marked to market on a regular basis. In the absence of market values, market risk is not a meaningful notion. Uncertainty in the economic value of the power plant represents business risk.
The distinction between market risk and business risk is ambiguous because there is a vast “grey zone” between the two. There are many instruments for which markets exist, but the markets are illiquid. Mark-to-market values are not usually available, but mark-to-model values provide a more-or-less accurate reflection of fair value. Do these instruments pose a business risk or market risk? The decision is important because firms employ fundamentally different techniques for managing the two risks.
Business risk is managed with a long-term focus. Techniques include the careful development of business plans and appropriate management oversight. book-value accounting is generally used, so the issue of day-to-day performance is not material. The focus is on achieving a good return on investment over an extended horizon.
Market risk is managed with a short-term focus. Long-term losses are avoided by avoiding losses from one day to the next. On a tactical level, traders and portfolio managers employ a variety of risk metrics —duration and convexity, the Greeks, beta, etc.—to assess their exposures. These allow them to identify and reduce any exposures they might consider excessive. On a more strategic level, organizations manage market risk by applying risk limits to traders’ or portfolio managers’ activities. Increasingly, value-at-risk is being used to define and monitor these limits. Some organizations also apply stress testing to their portfolios.
The market risk was unavoidable so we did our best to lay the foundation of success by executing our business plan perfectly.
Usually, the degree of Market Risk that is associated with a particular class of assets is in direct proportion to the rate of return, which is why I like the high risks in a stock purchase to get a big return.
By diversifying a retirement portfolio, an investor can mitigate market risk due to natural fluctuations and economic changes certain sectors of the market may experience.
noise trader risk
security market line
unsystematic risk
equity risk premium
International Swaps and Derivatives Association
McDonough ratio
naked position
Financial Risk Manager (FRM)
Vasicek interest rate model
undiversifiable risk
market risk premium
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This glossary post was last updated: 6th November, 2021 | 0 Views.