Table of Contents Hide
- What is Market Risk?
- Types of Systematic Risk
- Market risk premium
- Market Risk Premium Formula
- Market risk in banking
- How to manage market risks in banking
Taking huge risks in finance may seem like a bad idea for most people. But, sometimes there is more to gain if you are willing to act a bit dangerously. So we are going to see all about market risk and market risk premium. We will also get to know the different types. We will learn to calculate market risk premium using the formula and calculator. In addition, we will be able to look at market risks in banking and how to manage them. All these will help us to make better risks.
What is Market Risk?
The term Market risk refers to the risk that an investment may face due to fluctuations in the market. It covers all the risks of financial loss resulting from changes in market prices. The risk is that the venture’s value will reduce. Also known as systematic risk, the term may also refer to a specific currency or product.
We cannot only link Systematic risk with the company or the industry one is investing in; rather, it depends on the performance of the entire market. We show it generally in yearly terms, either as a fraction of the first value (e.g. 6%) or an absolute number (e.g. $6).
Systematic risk contrasts with specific risk, also known as business risk or unsystematic risk. It is tied directly with a market sector or the performance of a particular company. In other words, it refers to the total economy or securities markets, while specific risk involves only a part.
Thus, it is necessary for an investor to keep an eye on various small variables related to the commercial market. They include inflation, interest rates, the balance of payments situation, financial debts, geopolitical factors, etc.
Types of Systematic Risk
#1. Interest Rate Risk
This is the risk that comes from a rise or drop in interest rates. The risk arises from unanticipated changes in the interest rates due to monetary policy measures taken by the central bank.
#2. Commodity Risk
Certain goods, such as oil or food grain, are important for any economy and assist the production process of many goods. This is due to their use as secondary inputs. Any change in the prices of these products generally affects the performance of the entire market. It often results in a demand crisis.
#3. Currency Risk
Currency risk is also known as exchange rate risk. It refers to the possibility that foreign exchange rates will go up or down. We usually take the risk into study when making an international investment.
In order to decrease the risk of losing out on foreign investment, many rising markets maintain high foreign exchange reserves. Thus, ensuring that any possible loss can be canceled by selling the reserves.
#4. Country Risk
Many small variables, outside the control of a financial market, can affect the level of return due to an investment. They include the level of political balance, level of financial debt, prone to natural disasters, ease of doing business, etc. The degree of risk associated with such factors must be taken into consideration while making an international investment decision.
#5. Equity Risk
This is the risk that share prices will change. It is the financial risk involved in holding equity in a particular investment. Equity risk often refers to equity in companies through the purchase of stocks. It doesn’t commonly refer to the risk in paying into real estate or building assets in properties.
#6. Inflation Risk
Inflation risk is the chance that the cash flows from an investment won’t be worth as much in the future. This is a result of changes in purchasing power due to inflation. Another name for inflation risk is purchasing power risk.
Market risk premium
The is the rate of return on a risky investment. It is the difference between the expected return and the risk-free rate. It is part of the Capital Asset Pricing Model which we use to work out rates of return on investments. Ideally, an investment gives a high rate of return with low risk, however taking bigger risks can earn bigger rewards.
Types of Market Risk Premium
There are several areas that need to be considered when deciding this. They include:
#1. Historical market risk premium
The return’s past performance is used to determine the premium. This can vary depending on which instrument we use. Generally, the S&P 500 we use as a benchmark for understanding past performance.
#2. Required market risk premium
This is the least rate of return that investors should look for, sometimes known as the hurdle rate of return. If this is too low, investors are unlikely to invest. This will change from investor to investor.
#3. Expected market risk premium
Based on expectations, this will also change depending on the investor.
Other forces can impact it too. For example, the UK calculations may also want to consider economic events like Brexit.
Market Risk Premium Formula
In the capital asset pricing model (CAPM), the market risk premium shows the slope of the security market line (SML). We can derive this formula by subtracting the risk-free rate of return from the expected rate of return.
Mathematically, we can express it as, Market risk premium = Expected rate of return – Risk-free rate of return
or Market risk premium = Market rate of return – Risk-free rate of return
We can derive the formula in the first method by using the following simple four steps:
Step 1: Firstly, find out the expected rate of return for the investors based on their risk appetite. The higher it is, the higher would be the expected rate of return to compensate for the additional risk.
Step 2: Next, determine the risk-free rate of return. This is the return you expect if the investor does not take any risk. The return on government bonds or treasury bills is good substitutes for the risk-free rate of return.
Step 3: Finally, we derive the formula by subtracting the risk-free rate of return from the expected rate of return, as shown above.
We can also derive the formula of the calculation for the second method by using the following simple four steps:
Step 1: Firstly, determine the market rate of return, which is the annual return of a suitable benchmark index. The return on the S&P 500 index is a good proxy for the market rate of return.
Step 2: Next, determine the risk-free rate of return for the investor.
Step 3: Finally, we derive the formula by subtracting the risk-free rate of return from the market rate of return, as shown above.
Also, it can be calculated using a market risk premium calculator
Let’s see some simple to advanced examples of the Formula.
An investor who invested in a portfolio and expects a rate of return of 12% from it. In the last year, government bonds have given a return of 4%. Based on the given information, determine the market risk premium for the investor.
Therefore, the calculation can be done as follows,
Market risk premium = 12% – 4%
The result will be-
Based on the given information, the market risk premium for the investor is 8%.
An analyst wants to calculate the market risk premium offered by the benchmark index X&Y 200. This grew from 780 points to 860 points during the last year. Within this period, the government bonds have given an average 5% return. Based on the given information, determine the market risk premium using the formula.
To calculate this, we will first solve for the Market Rate of Return based on the above-given information.
Market rate of return = (860/780 – 1) * 100% = 10.26%
Thus, the calculation can be done as follows,
Market risk premium = 10.26% – 5% = 5.26%
A market risk premium calculator is a finance tool used for calculating the market risk premium. You can use the following Market Risk Premium Calculator.
|Expected Rate of Return|
|Risk Free Rate of Return|
|Market Risk Premium Formula|
|Market Risk Premium =||Expected Rate of Return – Risk Free Rate of Return|
|0 – 0 =||0|
It is important for an analyst or an investor to understand this because it goes around the relationship between risk and reward. It expresses how the returns of an equity market collection differ from that of the lower risk treasury bond yields. This is owing to the additional risk that is borne by the investor. Basically, the risk premium covers expected returns and historical returns. The expected market premium usually differs from one investor to another based on their risk appetite.
On the other hand, the historical market risk premium is the same for all the investors as the value is based on past results. Further, it forms a part of the CAPM, which has already been mentioned above. In the CAPM, the required rate of return of an asset is calculated as the product of market risk premium and beta of the asset plus the risk-free rate of return.
Market risk in banking
This mostly occurs from a bank’s activities in capital markets. It is due to the unpredictability of equity markets, commodity prices, interest rates, and credit spreads. Banks are more exposed if they are heavily involved in investing in capital markets or sales and trading. Market Risk in Banking is the possibility of a loss arising in either the Banking or Trading Book. This is when the values of the assets decrease as a result of increases in interest rates, volatility, and several other factors. If the Bank is short in some assets, then the risk is the increase in asset prices. It is mostly a Trading Book phenomenon.
How to manage market risks in banking
Market risk management involves developing a detailed and powerful structure. This is for monitoring, measuring, and controlling liquidity, interest rate, foreign exchange, and commodity price risks. Market risk management in banking should be combined with the institution’s business plan. In addition, stress testing can assess possible problem areas in a given portfolio.
Other ways banks reduce their market risks include hedging their investments with other, inversely related investments. Commodity prices also play a role because a bank may be invested in companies that produce commodities. As the value of the commodity changes, so does the value of the company and the value of the investment. Changes in commodity prices are caused by supply and demand shifts that are often hard to foretell. So, to decrease this, diversification of investments is important.
Every investment has its ups and downs. Investments involve different levels and types of risks. These risks can be associated with the specific investment, or with the marketplace as a whole. As you build and maintain your business, remember that global events and other factors you cannot control can affect your investments. Be sure to take both business risks and market risks into account. Although the market rate premium is able to offer guidance based on past performance, it should not be seen as a way of perfectly predicting future performance.