Managing Risk in Volatile Markets

A volatile market can present several challenges for investors and businesses. It can be difficult to manage risk effectively in such conditions.

It is paramount to understand the factors contributing to market risk, and to be aware of ongoing events which could impact this. Quantitative tools and techniques that help to measure and monitor market risk can be invaluable.

This post outlines some strategies for managing market risk in a volatile market, and the importance of staying informed in order to help mitigate risks effectively.

What is Market Risk, and why is it essential to manage it?

Market Risk is the risk of lower returns due to fluctuations in observable financial indicators. These indicators might include stock prices, commodity prices, exchange rates, or interest rates. Managing this type of risk is vital; it can significantly and unpredictably impact the value of investments, and hence the profitability of businesses. This is particularly true for complex assets whereby even small changes in these indicators can result in large changes in asset values.

Here are a few factors which are contributing to Market Risk in the current economic climate.

A backdrop of Covid

Whilst the worst of Covid is apparently behind us, significant market risk remains as the pandemic has generated increased economic uncertainty. This uncertainty is reflected in stock prices which are more volatile and prone to significant swings.

An unstable geopolitical situation

The current geopolitical situation in Eastern Europe is also contributing to market risk. The standoff between Russia and Ukraine, and the possibility of further escalation, adds to the likelihood of knock-on economic impacts in other regions.

Soaring commodities prices

Another factor driving market risk is the surge in commodity prices. This is caused by a) ever-increasing demand due to global consumption, and b) supply disruption caused by either political factors (e.g. conflicts, Brexit) or unforeseen circumstances (e.g. Covid). This is particularly evident in products such as copper and natural gas, which have each seen recent prices reach multi-year highs.

Measurements of Market Risk

A typical way to measure market risk is to use quantitative tools and techniques involving risk analytics. Such tools allow us to describe or quantify changes in financial indicators, such as price changes, volatility, and correlation. They also allow us to calculate a hypothetical value of our portfolio under different scenarios, corresponding to different combinations of the observable indicators that might occur.

For a given portfolio of assets, key measures of market risk include the so-called Greek metrics, which describe an asset’s sensitivity to changes in observable variables such as commodity prices, volatilities, or interest rates, and Value at Risk (VaR), which relates to the extent of losses that could be incurred over a short time interval.

These risk measurements and metrics are often not constant, and have to be recalculated frequently (e.g. one or more times every day) to provide a picture of how risks are evolving as the market moves and as new investment/trading decisions are made.

Strategies for mitigating Market Risk

Several strategies could be used to mitigate market risk in volatile conditions. One approach involves adjusting a portfolio to contain more defensive combinations of assets, such as those with lower levels of volatility and correlation. Another approach is to actively “hedge” or offset assets with each other, so that where an asset is exposed to multiple distinct market risks, some of those risks are offset by the equivalent risks in other assets, so the resulting portfolio is exposed to only the risks that one is comfortable with.

Any such approaches are often only temporary – they may result in lower risks at the current point in time, but those risks may increase again at later times due to market movements, and so the portfolio composition must be periodically “rebalanced” to restore market risks to comfortable levels.

Conclusion

To manage risk effectively, it’s essential to have access to the appropriate information to describe and quantify the risk, so that it’s possible to act on this information when necessary and avoid the possibility of financial returns outside of the expected range.

If you would like help with managing market risk in volatile conditions, you may consider seeking out specialist quantitative analytics skills. RocketFin is a leader in this field, offering advanced training and consulting services that can help maximise your success in managing market risks as they evolve.

With their expertise and experience, you can be confident that you are always making the most informed decisions possible about your financial assets.

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