Last updated on August 17th, 2024 at 05:47 am
Over the past few years, there has been substantial growth in the investment market. People are becoming more aware of recent economic trends. However, the long-term benefits of investment banking come with huge market risks.
It might sound daunting, but there are certain effective risk management techniques too to help with market risk. In this blog, we will discuss all of these in detail, so that you can invest consciously.
Market Risk Definition
The market risk definition is quite straightforward. The unpredictability surrounding any investment choice is referred to as market risk, often called systematic risk. Unexpected changes in variables that frequently impact the whole financial market are a typical cause of price volatility.
Market risk is determined by the performance of the market as a whole and is not specifically tied to the company or industry that an investor is participating in. An investor must thus keep an eye on several macro factors linked to the financial industry, such as interest rates, inflation, the equilibrium of payments, budget shortfalls, and regional issues.
Various Forms of Market Risk
- Interest Rate Risk
Interest rate risk results from unexpected changes in interest rates brought on by the monetary policies of the central bank actions. Long-term parity in the returns on securities provided across all markets requires a modification of market demand alongside supply for the instrument. Therefore, a rise in rates would result in a decrease in the price of the security. It is mostly connected to securities with fixed income. - Commodity Risk
Some commodities, like food grains or oil, are used as indirect inputs in the production of many other things and are therefore essential to every economy. Any fluctuations in commodity prices have a cascading effect on performance in the market and frequently lead to a supply-side crisis. - Currency Risk
Another name for currency risk is exchange rate risk. It speaks about the potential for a decrease in the return that an investor receives as a result of the worth of their native currency depreciating. Usually, while making an overseas investment, the risk is considered into account.
- Country Risk
Several macro issues that are outside the purview of the marketplaces might impact the return on investment. These include the degree of political stability, the degree of fiscal imbalance, the regulatory environment, the ease of doing business, and the vulnerability to natural disasters. When choosing to make an overseas investment, one must evaluate the level of risk involved with such elements.
Ways to Alleviate Market Risk
The risk cannot be minimised by diversification because it impacts the entire market, however, it may be hedged for low exposure. As a consequence, even with meticulous execution of basic and analytical research on the specific investment choice, investors may not receive the desired profits.
In addition to using techniques like Value at Risk (VaR) modelling to predict potential damage via quantitative risk management, professional analysts frequently view fluctuations, or the absolute/percentage variation in rates, as a useful indicator of market risk.
By comparing an asset's beta coefficient to the market as a whole, an investor can ascertain the degree of market risk volatility associated with that investment or portfolio. The capital asset pricing model (CAPM) is another tool used to calculate the projected return on an asset.
Risk Management in Investment Banking
Risk management in investment banking refers to the systematic process banks employ to identify, assess, and mitigate a variety of risks, such as credit, market, operational, and compliance risks that influence investment and operational decisions.
The process of systematically identifying, assessing, and minimising risks that a bank may face in the course of its regular business is known as banking risk management, and it is intended to guarantee stability and long-term sustainability.
In the banking industry, efficient risk management may support the preservation of the system's overall viability, investor and depositor interests, and financial stability. It's an important job that needs constant care and adjustment to the changing financial scene. Enrolling in an investment banking course could also be a great place to gain more knowledge related to risk management skills.
Important Steps of A Risk Management Process
The risk management process consists of these five fundamental steps, which are used to manage market risk:
- Identifying the Risk
- Analysing the Risk
- Evaluating the Risk
- Treating the Risk
- Monitoring the Risk
Step 1: Identifying the Risk
Determining the risks which the company faces in its operational environment is the first stage in the risk management process.
There are several varieties of dangers, including:
- Risks to the law
- Dangers to the environment
- Market dangers
- Risks related to regulations, etc.
This strategy has the benefit of making these risks obvious to all organisation stakeholders who have system access.
Step 2: Analysing the Risk
A market risk must be examined when it has been recognised. It is important to look at how many business operations the risk impacts to evaluate the risk's degree and significance. Certain risks, if they materialise, have the potential to completely collapse the company, while other risks in the analysis will simply cause minimal setbacks.
Step 3: Evaluating the Risk
Depending on how serious the risks are, most risk management solutions include many risk categories. A market risk that could end in a little dissatisfaction is rated low, whereas a market risk that could cause an enormous loss is rated maximum. Classifying risks is crucial since it provides an organisation with a comprehensive understanding of its overall risk exposure.
There are primarily two types of risk assessments: Qualitative Risk Assessment and Quantitative Risk Assessment
Step 4: Treating the Risk
Alerts may be delivered from inside the system to all pertinent stakeholders in a risk management solution. The risk may be discussed, as well as potential solutions, from within the framework. Furthermore, senior executives may closely monitor the advancements made inside the system and the remedies that are being proposed.
Step 5: Monitoring the Risk
Two types of risks that require constant monitoring are market risks and environmental risks. When using manual methods, watchful staff members do the monitoring. These specialists must maintain vigilant monitoring of all risk parameters.
The risk management system keeps an eye on the company's whole risk framework in a digital setting. Additionally, computers are far more adept than humans in constantly tracking risks.
All of these steps are covered in much more detail in any investment banking course.
Summing Up
Investing is necessary in today’s time. But, investing does come with its cons too. But if aspiring investors can follow the steps that have been discussed in this blog, steering away from risks and managing them can get easier.
Enrol in the Certified Investment Banking Operations Professional (CIBOP™) by Imarticus to learn more about market risks and risk management.
Frequently Asked Questions
- Why is risk management essential for banks?
For banks to preserve their credibility, maximise return on investment, guarantee financial stability, comply with legal obligations, and promote long-term development and long-term viability risk management is essential. - How is stress testing essential in risk management?
Stress testing helps banks find weaknesses and modify risk management techniques by modelling extreme market situations, recessions, or specific risks like loan defaults. This helps banks examine their resilience under undesirable scenarios. - In what ways can risk management help banks comply with regulations?
Identifying, assessing, and mitigating risks related to financial transactions, data security, anti-money laundering (AML) regulations, and client protection statutes are all part of risk management. By doing this, banks are guaranteed to adhere to regulatory standards. Enrolling in an investment banking course can also provide deeper insights into the varied benefits of risk management.
How can a bank assess and manage credit risk?
To assess credit risk, banks look at debtor repayment capacity, collateral, and financial condition. Examples of mitigation strategies include risk-based pricing, credit limit setting, and portfolio diversification.
