Market risk: what it is and how to protect investments

Market risk is a fundamental concept in the financial world and concerns unexpected changes in the value of assets and liabilities caused by changes in interest rates, exchange rates, and asset prices. It is one of the main risks to which every investor is exposed and can significantly affect the performance of his or her portfolio.

What is market risk?

Market risk refers to the possibility that the value of an investment will change due to general market movements. This risk can be divided into several subcategories, each of which is linked to specific variables. The main categories include:

• Interest rate risk: This refers to the risk that changes in interest rates will adversely affect the value of an investment, particularly for bonds and similar financial instruments.
• Foreign exchange risk: This is the risk related to fluctuations in exchange rates, which can impact returns on investments made in foreign currencies.
• Commodity risk: It concerns changes in the prices of commodities, such as precious metals or energy products, which can affect the value of investments in these sectors.
• Equity risk: It is associated with stock price volatility, which can lead to losses if the stock market undergoes sudden changes.

Derivative instruments as market risk hedges

Derivative instruments are an effective way to manage market risk, offering investors the opportunity to hedge their positions and mitigate the impact of changes in market prices. A common example are stock index futures, which allow investors to protect a portfolio of stocks from fluctuations in stock market indices by balancing losses on the stocks with gains on the derivative.

In addition to stock index futures, options are also a valuable tool for hedging against unexpected movements, offering flexibility without having to give up potential gains. Swaps and futures contracts, on the other hand, are used to hedge interest rate and foreign exchange risks. However, the use of derivatives requires good market knowledge to avoid amplifying risks.

Systematic risk and specific risk

In the context of market risk, it is important to distinguish between systematic risk and specific risk:

• Systematic risk: This is the risk associated with global economic and financial factors, such as an economic recession or financial crisis. This type of risk cannot be eliminated through portfolio diversification, as it affects all markets in general. It is measured by the beta coefficient, which indicates the sensitivity of a stock to the performance of the market as a whole.
• Specific risk: Relates to the performance of a single company or a specific sector. This type of risk can be reduced through diversification by investing in a wide range of different securities.

Market risk management

To reduce exposure to specific risk, investors can opt for appropriate diversification of their portfolios, for example, by investing in mutual funds or investment companies with variable capital (SICAVs). In this way, risk can be spread across multiple securities and sectors, reducing the likelihood of significant losses from isolated events.

In contrast, systematic risk is unavoidable, and despite diversification, the portfolio remains exposed to global events, such as economic crises or international conflicts. For this reason, investors should be remunerated for taking on this type of risk, as it cannot be eliminated.

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