Categories of Market Risk
Interest rate risk
Interest rate is the cost of borrowing. Interest rate risk is the risk arising from interest rate fluctuations, rendering the returns on financial assets uncertain (Bansal et al., 1991). Changes in interest rate will impact different financial assets such as bonds. Bonds have a negative relationship with interest rates. As interest rates increase the value of bonds will fall. Fixed income securities have an inverse relationship with interest rates. When interest rates decrease the value of fixed income securities will go up, older rates are more attractive than new rates.
| South Africa – Key Rates | |
| Date | Key Rates |
| 2016-03-18 | 7.00% |
| 2017-07-21 | 6.75% |
| 2018-03-29 | 6.50% |
| 2018-11-23 | 6.75% |
| 2019-07-19 | 6.50% |
| 2020-01-17 | 6.25% |
| 2020-03-20 | 5.25% |
| 2020-04-15 | 4.25% |
| 2020-05-22 | 3.75% |
| 2020-07-24 | 3.50% |
Source: (“South Africa Central Bank key rates 2020,” n.d.) countryeconomy.com
According to “South Africa Central Bank key rates 2020,” (n.d.) the SARB has lowered interest rates by 0.25% from 3.75% to an annual rate o 3.50%, this has the effect of increasing inflation. When the SARB lower interest rates, the cost of borrowing is low, individuals and companies will increase their borrowing level subsequently increasing the general economic activity. This has the effect of more disposable income in the South African economy inducing demand-pull inflation. We can therefore conclude that there is a negative relationship between interest rates and inflation holding other things constant.
Exchange rate risk
The exchange rate is the value that one currency exchanges for another. Consider the following example: In 2010 you wanted to purchase equipment for your business in the USA you didn’t have enough money to pay for the equipment. Your good friend who relocated to the USA some 10 years ago agreed to offer you a soft loan of US$50 000 to be repaid in 5 years. We need to calculate how changes in exchange rates will affect your business.
The exchange rate between the US$ and Rand
| Year | Rand vs Dollar |
| 2010 | 7.46 |
| 2011 | 6.91 |
| 2012 | 7.59 |
| 2013 | 9.11 |
| 2014 | 10.79 |
| 2015 | 12.26 |
| 2016 | 15.23 |
Source: (“Rand vs the dollar: 1978 – 2016,” n.d.), countryeconomy.com
Lets us now consider the effects of changes in the exchange rate for your business.
- In 2010, US$1 = ZAR7.46
- US$50 000 = ZAR373 000
If you had enough money in 2010 you need only ZAR373 000 to pay for the equipment.
Let us now consider the year 2015, 5 years later when you are paying pack your friend.
- US$1 =ZAR12.26
- This means US$50 000 = ZAR613 000
Let’s calculate your loss due to changes in the exchange rate
| Borrowing year (2010) US$1: ZAR7.46 | Repayment year (2015) US$1: ZAR12.26 |
| US$50 000= ZAR373 000 | US$50 000 = ZAR613 000 |
| Profit/Loss = Repayment amount-Borrowed amount
Loss = ZAR613 000- ZAR373 000 =ZAR240 000 |
|
We can observe from the table that if we delay repayment up to 2016, the total will be
ZAR761 500
Question: What if we paid the loan in 2011, what was going to be our profit or loss?
Inflation Risk: Purchasing power risk
The risk that cash flows from an investment will be adversely affected. According to Bekaert and Wang, (2010), inflation risk affects both individuals and corporate investors. Inflation is one of the economic evils, its effects perpetuate to almost every individual in the economy. Purchasing power can be defined as buying power, as inflation increases the buying power is eroded. Inflation is defined as a general increase in the price level. In other terms, we can define it as too much money chasing few goods. Inflation has the effect of negatively affecting the real value of income from fixed income securities.
Commodity Risk
According to Deloitte (2018), Commodity price risk is the financial risk on an entity’s financial performance/ profitability upon fluctuations in the prices of commodities that are out of the control of the entity since they are primarily driven by external market forces. The change in the prices of major commodities affects the entire market. Food and agricultural commodities, energy commodities and mineral and metals commodities are the major international commodities(Pilar Fajarnes, 2011).
Bibliography
- Bansal, A., Kauffman, R.J., Mark, R.M., Peters, E., 1991. Financial Risk and Financial Risk Management Technology (Rmt): Issues and Advances (SSRN Scholarly Paper No. ID 1289046). Social Science Research Network, Rochester, NY.
- Bekaert, G., Wang, X., 2010. Inflation risk and the inflation risk premium: INFLATION RISK. Economic Policy 25, 755–806. https://doi.org/10.1111/j.1468-0327.2010.00253.x
- Deloitte, 2018, Commodity Price Risk Management, A manual of hedging commodity price risk for corporates
- South Africa Central Bank key rates 2020 [WWW Document], n.d. . countryeconomy.com. URL https://countryeconomy.com/key-rates/south-africa (accessed 3.3.21).