Investment in the capital market exposes the investor to capital market risk. Investment in long term financial instruments is also accompanied by high capital market risks. Since there are two types of capital markets- the stock market and the bond market, we may study the capital market risk that each is exposed to.
Capital Market Risk in the Stock Market
Stock prices keep fluctuating over a wide range unlike the bank deposits or government bonds. This has a considerable effect on not only the individual investors or the household but the entire economy.
The efficient market hypothesis shows the effect of fundamental factors in changing the price of the stock market. This hypothesis could not check the stock market crash in 1987 when the Dow Jones Index fell by 22.6 %. This shows that the share prices can fall also without any detectable reason. The Efficient Market Hypothesis shows that all price movements are random whereas there are plenty of studies that reflect the fact that there is a specific trend in the stock market prices over a period of time.
Research has shown that there are certain psychological factors that shape the stock market prices. Sometimes people tend to see patterns and make 'noise' although no such patterns may exist. Individuals are also victims of group thinking.
Sometimes the market behaves illogically to any economic news. The stock market prices can be diverted in any direction in response to press releases, rumors and mass panic. The stock market prices are also subject to speculation. In the short run the stock market prices may be very volatile due to the occurrences of the fast market changing events.
Capital Market Risk in the Bond Market
There are market participants who own the bond, collect the coupon and hold it till the expiry of the maturity date. These market participants do not face any capital market risk. Capital market risk is faced by individuals who buy or sell the bonds before it expires. Capital market risk in the bond market arise due to interest rate changes. There is an inverse relationship existing between the interest rate and the price of the bonds. Interest rate changes occur due to a change in the monetary policy of the country and such interest rate changes lead to the change in the bond prices in the reverse direction. Hence the bond prices are sensitive to the monetary policy of the country as well as economic changes.
For more details on the capital market risk the websites worth viewing are riskcenter.com, mindtree.com, aon.com, cmra.com etc.