Nowadays, with the word “recession” hanging over everybody, people are becoming more aware and conscious about their economic and financial situations. Many are seeking to become more educated on financial matters, and this action is in fact a good idea; it will be easier to beat a situation if you know as much about it as you can.
Perhaps one of the issues that you’d like to get to know more of is about how do the government and other industries use risk models to forecast market volatility. First of all, it’s important to define some terms:
- What is market volatility? It is the measure of how unstable the trade and commerce industry is, and how big a chance a certain investment has for becoming a failed venture.
- What are risk models? In general terms, they are the use of various financial techniques or methods to measure the risk or uncertainty of investing in certain business enterprises, stocks or financial portfolio.
To find out how to use risk models to forecast market volatility, it may help to look at the different risk models and to know volatility modeling and see how they work:
- Market Risk models. These show the possibility of the decrease of a value of an asset due to multi-factor trends such as fluctuating interest rates, stock and commodity prices, and foreign exchange rates. Some market risk factors include equity risk (or the chance that interest rates will decrease), currency risk (pertains to foreign exchange), equity risk (pertains to stock prices), commodity risk (refers to a change in commodity prices) and operational risk (based on business functions of the specific company). To use a market risk model for forecasting volatility, these elements must be adequately factored in on the equation. Sufficient preparation must also be done to counter volatility, such as credit risk management and insurance to cover for losses.
- Value at Risk models. This model aims to measure the possibility of loss on a portfolio of assets through a statistical and mathematical analysis of market price trends and historical patterns of volatilities, and assuming a currently neutral market (meaning, free from radical economic fluctuations). A close and intensive look at previous financial and commercial movements and developments must be done when using this model.
- Liquidity models. Liquidity models forecast the possibility that an asset or security will not be traded quickly or easily enough in the market, and will therefore run the risk of loss. These models are usually used to measure how viable it is to buy stocks and securities, taking into consideration how soon you’d need to have it traded or liquidated.
- Derivatives models. Derivatives models measure the possibility of the underlying value of the trading instrument (be it an asset, real estate, bond or loan) would decrease. Since derivatives are considered to be very risky investment options (even bordering on speculation), derivatives models are useful in avoiding huge amounts of losses and in correctly predicting a future underlying value of a trading instrument.