-By Suhani Gour
A financial market is a marketplace or system where individuals, institutions, and entities trade various financial assets and instruments. There are several kinds of markets catering to various financial instruments and purposes such as the stock market, bond market, commodity market, FOREX market, money market, etc. Financial markets are dynamic and complex systems in which various sources of stress can impact the functionality and stability of the market. Here comes the concept of market stress.
Financial market stress
Financial market stress refers to a state of turmoil in financial markets. It typically occurs when there is uncertainty in the normal functioning of the financial market. This uncertainty can be because of increased market participation, deterioration in credit markets, surge in trading volumes and liquidity problems, increased uncertainty about economic conditions, and many more. To understand it in a more precise manner let’s get back to the year 2020, the spread of COVID-19 led to economic shutdowns and such lockdowns caused widespread economic disruptions. With such a condition financial markets initially experienced sharp declines.Various factors including economic recession, geopolitical events, financial crises, regulatory changes, or unexpected shocks to the system can trigger market stress. Financial investors closely monitor market stress levels as they help in investment decisions, risk management, and financial stability.For instance, the European debt crisis in 2010-2012, led to distress about the future of the euro and the stability of the European Union.
Financial Markets are inherently volatile. Volatility here means the degree of variation in the price or value of a financial instrument over time. In other words, it can measure the uncertainty or risk associated with an asset’s future price movements. It can be said that Volatility is a double-edged sword as it provides opportunities for traders to gain profit from price fluctuations whereas it also increases risk.
Market stress and volatility are indeed essential when it comes to risk measurement in financial markets because they are key factors in understanding and quantifying the inherent risks associated with financial assets and portfolios. Systematic risk also known as market risk is the risk that is inherent to the entire market or a specific asset. This risk cannot be eliminated through diversification as it is related to factors that affect all assets or a portion of them.
Many risk measurement models and techniques such as Value at Risk (VaR) incorporate volatility as a key input. These models help in estimating the different kinds of losses a portfolio may incur in different market conditions. There are several ways to measure systematic risk in financial markets, the most common of them include:
· Beta – Beta is a widely used measure of systematic risk. It is a metric that measures the sensitivity of an asset’s returns to the returns of a broader market index. Beta helps investors and analysts to assess the level of systematic risk associated with a particular asset. For example, Apple Inc. (AAPL) has a beta of 1.23, which shows that its stock price is expected to move 1.23 times as much as the overall market. In other words, if the market goes up 10%, AAPL’s stock price is expected to go up 12.3%. This is because it is considered a volatile stock. This means that its stock price is more likely to move up and down sharply than the overall market. However, beta is just a component of risk analysis and it has limitations too.
· Market Index Performance – Market risk can also be assessed by monitoring the performance of a broad market index. If the market index shows significant fluctuations or draws a downward trend, it can be an indicator of increased systematic risk in the market. For example, on October 4, 2023, the S&P 500 index, a broad measure of health of the U.S. stock market, was trading at 3,666.01 points. This was up 2.62% from the previous day’s close of 3,563.24 points. This index was also up 14.74% year-to-date.
· Standard Deviation - Standard deviation is a statistical measure that quantifies the degree of variation in a set of data. It is often used to assess the historical price volatility of a financial asset. Usually, a higher standard deviation is the indicator of greater risk.
· Alpha – Alpha is a measure of an investment’s risk-adjusted performance. It evaluates an asset’s return relative to its expected return given its level of risk. Positive alpha suggests that the investment outperformed expectations.
· Correlation and covariance – correlation and covariance measurements are used to assess the relationship between the returns of different assets in a portfolio. A low or negative correlation suggests diversification benefits, an asset may not move in sync. For example, An investor is considering investing in two stocks, Apple (AAPL)and Microsoft (MSFT). The investor wants to know how the two stocks tend to move together, so they calculate the correlation coefficient between AAPL and MSFT which came to be 0.8. this means that the two stocks have strong positive correlation. This means that the two stocks tend to move in the same direction. The investor also calculates the covariance between AAPL and MSFT. The covariance is 100. This means that the two stocks are not good diversifiers, as they will both tend to move in the same direction.
These kinds of risk measurement tools are used in combination to provide a comprehensive assessment of various types of financial risk, including market risk, credit risk, operational risk, etc. Many more measurement tools can be used for specific contexts and the type of risk being evaluated.
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