Market risk is the common risk associated with the value of a group of assets or investments. An investment’s value is subject to the economic changes and events of the marketplace. Therefore, significant positive or negative changes in the market may severely impact the value of assets or investments held by companies or individuals. An example of this on a large scale is the U.S. housing bubble of 2005-2008; subprime mortgages written to individuals unable to repay the loans carried high risk for lenders. This unsustainable bubble burst, triggering a major financial collapse in the banking and mortgage industries.
Economic transactions carry an inherent risk for each party involved in the transaction. For example, the subprime mortgages sold during the housing bubble were re-sold to banks and investment groups, spreading the risk around the economic marketplace. Companies chose to invest in the subprime mortgages and collateralized debt because the payoff was extremely profitable, despite the risk.
Diversifying asset and investment portfolios may limit the risk found in certain groups of investments. Companies may be able to lessen the impact of risk by owning several different types of investments. Because market risk varies based on the type of asset or investment in the economic marketplace, owning several different investments can create a lower probability of severe market risk. Traditional safe investments include gold or other commodities, government bonds, cash and money markets. Higher risk investments include corporate stocks, business bonds, derivatives or collateralized debt obligations.
Each asset or investment group reacts differently to economic changes. Companies can use technical finance formulas or market analyses to determine which investments offer the safest return under certain market conditions. Large companies often employ business analysts and accountants to perform these calculations and carefully monitor the company’s overall market risk. Finance formulas, such as the capital asset pricing model (CAPM) or the weighted average cost of capital (WACC), help companies determine how much market risk is safe before the company will begin to suffer the negative effects of risk.
In the United States (U.S.), the U.S. Securities and Exchange Commission (SEC) requires publicly held companies to publish disclosures in their annual financial reports released to the public. Information disclosed typically must include policies on accounting for derivatives and qualitative or quantitative information on the company’s exposure to overall market risk. External stakeholders and investors may use these disclosures to determine the financial strength of companies and their stability in the economic marketplace. Private companies are not subject to these rules; however, independent audits may detail the market risk exposure for these businesses.