What is Market Risk, Price Risk and Interest Rate Risk

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Market Risk and Price Risk

When securities are traded in an open market, people can buy or sell the same based on their opinions. It does not matter whether these opinions are based on facts, or otherwise. Since the opinions may change very fast, the prices may fluctuate more in comparison to the change in facts related to security. Such fluctuations are also referred to as volatility.

There are two types of risks to a security—market risk and price risk.

Let us understand this through an example. When there is a possibility of a country getting into a warlike situation, there is a widespread fear that this may impact the economy and the companies within it. Due to such a fear, it is quite possible that the prices of all stocks (or at least a large number of stocks) in the market may witness a fall.

This is a market-wide fall. On the other hand, when the sales of a company’s products fall, due to technological changes, or the arrival of a better product, the company’s share price falls. During such times, there could be many other companies, whose share prices may rise. This is an example of a company specific risk.

As is evident from the discussion, the stability of the company’s business and the profitability of the firm play a major role with respect to company specific risk factors.

Between the general, market-wide factors and firm-specific factors, there could be some industry-specific factors, which would impact all the firms within the same industry. For example, if the Government policy changes with respect to a particular industry, all the firms may get impacted.

Similarly, if a new and better technology becomes available, all the firms within the same industry that use the old technology may get impacted. This happened when mobile phones started becoming popular, the pager industry vanished in less than a couple of decades.

The risk specific to the security can be reduced through diversification across unrelated securities, but the one that is market-wide cannot be reduced through diversification. 5

Interest Rate Risk

Interest rate risk is the risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bonds/debt instruments more directly than stocks. Any reduction in interest rates will increase the value of the instrument and vice versa.

While most investors are familiar with the concept of debentures, they normally buy and hold these bonds till maturity. On maturity of the bond, they get the maturity amount, since it is part of the bond agreement (assuming the company does not default on the commitment).

On the other hand, if an investor sells the bond in the secondary market, one would have to do the transaction at the current market price. This price depends on many factors, but chief among these is the change in the interest rates in the economy. The relationship between interest rates and bond prices is inverse. When the interest rates in the economy increase, the prices of existing bonds decrease, since they continue to offer the old interest rates.

Assume that a bond was issued at Rs. 1000 for one year, and it offered an interest rate of 8 percent. Immediately after the bond was issued, the interest rates in the economy increased, and new bonds are now offering 8.5 percent interest. In such a case, the earlier bond becomes less attractive. If the investor who invested in that bond wants to sell, it can only be done at a discount. The reverse is also true. If in the above example, had the interest rate moved down, the price of the bond would have moved up. The interest rate risk varies for bonds with different maturities. Those with longer maturity would witness higher price fluctuations in comparison to those with shorter maturities. Such movements in bond prices on account of changes in interest are referred to as “interest rate risk”. This is a market-wide factor affecting the prices of all bonds.

Disclaimer:         The information set out above is included for general information purposes only and is not exhaustive and does not constitute legal or tax advice. All complaints regarding Mutual Fund can be directed towards visit www.scores.gov.in (SEBI SCORES portal). Readers are requested to make informed investment decisions and consult Chaitanya Financial Consultants – 9000628943 / mfd.mmr@gmail.com to determine the financial implications with respect to investing in Mutual Funds.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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