Market risk
What is Market risk?
Market risk is the possibility of loss caused by movements in equity prices, interest rates, credit spreads, currencies, commodities, volatility, or other traded market variables.
Why market risk matters
Market risk affects portfolios even when every issuer meets its obligations. Prices respond to new information, discount rates, positioning, and liquidity, creating gains and losses before securities mature or are sold. Asset managers need to understand both ordinary fluctuations and severe scenarios because market exposure influences performance, collateral, redemptions, and the ability to rebalance.
How it is measured
Common measures include volatility, beta, duration, option sensitivities, value at risk, expected shortfall, drawdown, and stress loss. Each captures a different feature. Sensitivity measures describe response to small moves, distribution measures summarize modeled outcomes, and scenarios examine specified shocks. A complete view maps instruments to underlying risk factors before aggregating their effects.
Example
A corporate-bond portfolio faces interest-rate risk from government yields and spread risk from changing compensation for credit. Even with no defaults, a rise in both can reduce market value. A foreign bond may add currency risk, while an embedded option can cause sensitivity to change as rates move. The combined loss can be nonlinear.
How to interpret it
State the horizon, confidence level, currency, benchmark, and valuation convention for every market-risk figure. Compare current exposure with limits and with stressed exposure. A low recent volatility estimate may reflect a calm sample rather than durable safety. Examine concentrations and liquidity because a position that appears moderate under normal moves may be difficult to exit during stress.
Limitations
Models can omit risk factors, assume stable relationships, or approximate nonlinear instruments poorly. Historical data may contain too few crises, while hypothetical shocks can be internally inconsistent. Market risk also interacts with credit, funding, counterparty, and liquidity risk. No single metric should be treated as a complete estimate of the amount a portfolio can lose.
Practical checklist
Inventory every material market factor and reconcile sensitivities with holdings and valuation systems. Measure risk using complementary methods and test simultaneous shocks. Track changes caused by trades, market movement, and model updates separately. Escalate limit breaches with enough detail to identify the driver. Backtest model forecasts where appropriate, but retain scenarios that address plausible events absent from the historical sample.
Sources and further reading
- What is Risk?, Investor.gov, U.S. Securities and Exchange Commission
- Measuring and Managing Market Risk, CFA Institute