Market risk cannot be eliminated and all investments are exposed to it. But, being able to measure market risk can be a great help when making investment choices.
Investing in any market can be an excellent way for an investor to preserve or build wealth, be it stocks, bonds, or others investments. Seemingly random highs and lows of a market can exhilarate or depress investors depending on what their risk tolerances are, and some say that it behaves like something alive with its very own psychology. Whatever an investor's stance happens to be concerning this, everyone will probably agree that no investment is totally risk free. Market risk is one of the multiple risk types that investments are exposed to. How is market risk measured? Read on.
What is Market Risk?
Risk can be defined as the possible outcome of an event or an investment return regarded to be detrimental to an investor rather than beneficial. There are two fundamental types of risk that most other investment risks fall into. These are systematic risk and unsystematic risk. Market risk belongs to the first one.
Systematic risk is the risk associated with an investment in a market that a large number of assets, or possibly all assets, are exposed to and from which they cannot be protected. The amount of market risk for an investment depends on how closely it correlates to the market.
Market risk is the risk that a security is exposed to through daily price fluctuations (volatility) in a market's movements that are most commonly associated with stocks and options. It belongs to the systematic type of risk and can't be eliminated through the diversification of investments.
Measuring Market Risk
All the investments in a market have their own market risk. The old familiar relationship of risk and return applies here as it does with any other kind of investment risk: the higher the risk the higher the return, and the lower the risk, the lower the return. Investments can't be protected from volatility but they can be chosen at acceptable levels of it in a general way. So how is market risk measured?
One of the most common measures of an investments volatility in relation to the market, or market risk, is the beta, also known as the beta coefficient. It is calculated using a statistical method called regression analysis that produces a number indicating how closely an investment's market prices correlates to those of the whole market, or a market index considered representative of the market. The beta of the market is considered to be 1.0 and all of the assets within it will have betas that are above or below this.
- Companies with a beta of 1 indicates an exact one to one correlation with the market.
- Companies with betas of 1.5 are considered to fluctuate with 50% more volatility than the market.
- Those with a beta of .7 are considered to fluctuate with only 70% of the market's volatility.
- A negative beta of less than 0 would indicate companies that move opposite, or inversely, to the markets price movements.
- A beta of 0 would be no correlation to a market and a price that remains unchanged. This would be cash.
It stands to reason that higher betas provide higher returns and that lower betas provide lower returns.
Beta is an easy to comprehend measure and relatively easy to calculate. It's basically a composite of historical data that covers a specific time frame and can always change as time goes on. This makes it a poor tool for determining future price movements. A statistical measure known as R-squared calculates how useful a particular beta is in explaining a securities price movements utilizing a scale of values between 0 and 100. On this scale high values would indicate more usefulness and low values would indicate betas to be ignored. Most investment rating services and some financial websites provide the beta for each security listed there.
Capital Asset Price Model
The Capital Asset Price Model (CAPM) is used by some investors and analysts to calculate the cost of equity and uses the beta as one of its key factors. One of the ideas of this is if the expected return of an investment is less than the risk-free rate plus a risk premium then an investment shouldn't be entered into. It uses this equation for determining the relationship between risk and return in pricing risky securities:
era = rf + ßa (erm - rf)
era = Expected rate of return for the security
rf = Risk free rate (A rate of return on a benchmark investment that is considered risk-free. US Treasuries are used quite often for this.)
ßa = Beta of the security
erm = Expected market rate
(erm - rf) = Equity market premium
(Use of the variable "er" for representing "expected return" is a departure from the original equation due to limitations of the editing software being used for this article.)
Market Risk in Perspective
Market risk, or volatility, by its very nature is one that investments can't be protected from. But it can be measured using statistical methods to produce a value called beta. This value indicates how volatile an investment has been historically in relation to the whole market for a given time period. This can be of some value to investors trying to find investments that are likely to stay within their own level of risk tolerance. A model called the Capital Asset Price Model uses beta to help determine the expected returns on risky securities. There are other different types of risks and other risk measures for investments and portfolios. Market risk and the beta are just part of the many that there are.