Question

What are the primary sources of market risk and the primary sources of diversifiable risk?

Explain both with examples.

Answer 1

Primary source of market risk

Market risk is the risk of uncertainty in the final value of an investment due to fluctuation in the market place. Market movement is generally unpredictable and accurately ascertaining the trend or future movement is impossible. This makes ascertaining the future values of the asset also impossible. This poses a risk to the investor as he cannot be sure that any day his asset will be worth any particular value. This is the market risk the investor faces. For example assume Mr A purchases a ALIBABA stock for $175 today. A month later, the market is generally down and all stocks are seeing a general downward trend and Alibaba trends at $160. Here Mr A has a loss of $15 on 1 stock he owns. This is the market risk Mr A is carrying. As this is market specific risk, it cannot be eliminated/removed from diversifying the portfolio as all the stock will be effected by market specific parameters. Thus market risk is non diversifiable in nature.

Primary source of diversifiable risk

Diversifiable risk is defined as any risk from holding that company or stock which can some day lead to drop in share price and thus loss to the shareholder. Here the market as whole is not impacted but only the concerned company/stock.In the above case, the loss for Mr A from drop in share price of Alibaba which was due to some issue within Alibaba and not due to any market wide issue is a diversifiable risk related to Alibaba which can be eliminated/diversifiable from investing in other firms.

A rational investor would ideally not put all his eggs in the same basket. He would rather than putting all his money in one stock, would buy multiple stock in different sectors/company's. Thus if one company experiences loss in share price and other experi a gain, the investor is not experiencing a huge loss. Diversifiable risn is thus a risk that can be removed/eliminated by diversifying the portfolio sufficiently so that any kind of market scenario do not bring losses to the investor from the portfolio.

Diversifiable risk can be of different types. For example: 1) Company specific risk is knee such risk which can be removed/eliminated by using derivatives or using other methods 2) currency risk is also a risk which can be eliminated by diversifying the portfolio and using derivatives like curry futures or options 3) Interet rate risk also can be diversified/eliminated using derivatives