Price Risk
What Is Price Risk?
Price risk is the risk of a decline in the value of a security or an investment portfolio excluding a downturn in the market, due to different factors. Investors can utilize a number of devices and techniques to hedge price risk, going from generally conservative choices (e.g., buying put options) to additional aggressive strategies (e.g., short selling).
Understanding Price Risk
Price risk relies on a number of factors, including earnings volatility, poor management, industry risk, and price changes. A poor business model that isn't sustainable, a misrepresentation of financial statements, inherent risks in the cycle of an industry, or reputation risk due to low confidence in business management are areas that will influence the value of a security. Small startup companies generally have higher price risk than bigger, deep rooted companies. This is mostly on the grounds that in a bigger company, the management, market capitalization, financial standing, and geographical location of operations are commonly more grounded and better prepared than smaller companies.
Certain commodity industries, like the oil, gold, and silver markets, have higher volatility and higher price risk also. The raw materials of these industries are defenseless to price changes due to various global factors, like politics and war. Commodities likewise see a ton of price risk as they trade on the futures market that offers high levels of leverage.
Diversification to Minimize Price Risk
Not at all like different types of risk, price risk can be marked down. The most common moderation technique is diversification. For instance, an investor possesses stock in two contending restaurant chains. The price of one chain's stock falls in light of a flare-up of foodborne illness. Subsequently, the contender understands a flood in business and its stock price. The decline in the market price of one stock is compensated by the increase in the stock price of the other. To additionally reduce risk, an investor could purchase stocks of different companies inside various industries or in various geographical locations.
Futures and Options to Hedge Price Risk
Price risk can be hedged through the purchase of financial derivatives called futures and options. A futures contract commits a party to complete a transaction at a foreordained price and date. The buyer of a contract must buy and the seller must sell the underlying asset at the set price, no matter what some other factors. An option offers the buyer the opportunity to buy or sell the security, contingent upon the contract, however they are not required to.
The two producers and consumers can utilize these instruments to hedge price risk. A producer is worried about the price moving lower and a consumer is worried about the price moving higher. An investor, contingent upon the position they take in an investment, will be worried about the price moving the other way of that position, and in this manner can utilize a future or option to hedge the opposite side of the trade.
Illustration of an Option
A put option gives the holder the right, yet not the obligation, to sell a commodity or stock at a specific cost in the future no matter what the current market rate. For instance, a put option might be purchased to sell a specific security for $50 in six months. Following six months, on the off chance that price risk is realized and the stock price is $30, the put option might be worked out (selling the security at the higher price), accordingly relieving price risk.
Short Selling to Hedge Price Risk
Price risk might be capitalized through the utilization of short selling. Short selling includes the sale of stock where the seller doesn't possess the stock. The seller, expecting a reduction in the stock's price due to price risk, plans to borrow, sell, buy, and return stock. For instance, upon the conviction of a specific stock's inescapable downturn, an investor borrows 100 shares and consents to sell them for $50 per share. The investor has $5,000 and 30 days to return the borrowed stock they sold. Following 30 days, assuming the price of the stock dropped to $30 per share, the investor can purchase 100 shares for $30, return the shares from where they were borrowed and keep the $2,000 profit due to the impact of price risk.
Highlights
- Diversification is the most common and effective device to moderate price risk.
- Factors that influence price risk incorporate earnings volatility, poor business management, and price changes.
- Price risk is the risk that the value of a security or investment will diminish.
- Financial instruments, like options and short selling, can likewise be utilized to hedge price risk.
