Definition of Risk
Risk involves the chance an investment's actual return
will differ from the expected return. Risk includes the
possibility of losing some or all of the original investment.
Sources of Risk
1. Interest Rate Risk
Is the possibility that the value of an investment will
decline as the result of an unexpected change in interest
rates.
2. Inflation Risk
It is also called purchasing power risk, is the
chance that the cash flows from an investment won't be
worth as much in the future because of changes in
purchasing power due to inflation.
3. Business Risk
Is the risk that a business future operating profits
may drop due to adverse changes in operations.
4. Financial Risk
It is the possibility that shareholders or other
financial stakeholders will lose money when they invest
in a company that has debt. If the company's cash flow
proves inadequate to meet its financial obligations.
5. Liquidity Risk
Occurs when an individual investors, business or
financial institutions cannot meet short-term debt
obligations. The investors or entity maybe unable to
convert an asset into cash without giving up capital
and/or income due lack of buyers or inefficient market.
6. Country Risk
Is a collection of risk that are associated with
investing a foreign country instead of investing in a
domestic market.
Alpha
Alpha or Jensen Index (invented my Michael Jensen in
the 1970s) is an index that is used in some financial
models such as the capital asset pricing model (CAPM)
to determine the highest possible return on an
investment for the least amount of risk.
In other words, Alpha measures how well an investment
performed compared to its benchmark.
In finance, Jensen’s index is used to determine the
required excess return of a stock, security or portfolio. It
uses a relationship between risk and return (technically
called “security market line”) as a benchmark. The
number you get shows how much better or worse an
investment performed relative to its benchmark. Thus, it
allows the investor to statistically test whether portfolio
produced an abnormal return relative to the overall
capital market i.e. whether the manager’s skill has added
value to a fund on a risk-adjusted basis. Bluntly
speaking, it tells you if investment decisions were good
or bad.
Jensen’s Alpha causes some debates, however, as
some economists argue that most managers fail to beat
the market over the long run due to the efficient market
hypothesis, and therefore attribute Alpha to luck instead
of portfolio managers’ skills.
'Capital Asset Pricing Model - CAPM'
The capital asset pricing model (CAPM) is a model that
describes the relationship between systematic risk
and expected return for assets, particularly stocks.
CAPM is widely used throughout finance for the pricing
of risky securities, generating expected returns for
assets given the risk of those assets and calculating
costs of capital.
CAPM formula is expressed as follows
r = Rf + beta * (Rm – Rf ) + Alpha
Thus,
Alpha = r –[ Rf – beta * (Rm – Rf )]
r = the security’s or portfolio’s return
Rf = the risk-free rate of return
beta = systemic risk of a portfolio (the security’s or
portfolio’s price volatility relative to the overall market)
Rm = the market return
Beta
Also known as the "beta coefficient," is a measure of
the volatility, or systematic risk, of a security or a
portfolio in comparison to the market as a whole.
Beta is calculated using regression analysis, and you
can think of it as the tendency of an investment's return
to respond to movements in the market.
Beta Coefficient
Beta coefficient is a measure of sensitivity of a share
price to movement in the market price. It measures
systematic risk which is the risk inherent in the whole
financial system. Beta coefficient is an important input in
capital asset pricing model to calculate required rate of
return on a stock. It is the slope of the security market
line.
Here is a basic guide to various betas:
Negative beta - A beta less than 0 - which would
indicate an inverse relation to the market - is possible
but highly unlikely. Some investors used to believe that
gold and gold stocks should have negative betas,
because they tended to do better when the stock market
declined, but this hasn't proved to be true over the long
term.
Beta of 0 - Basically, cash has a beta of 0. In other
words, regardless of which way the market moves, the
value of cash remains unchanged (given no inflation).
Beta between 0 and 1 - Companies with volatilities
lower than the market have a beta of less than 1 (but
more than 0). As we mentioned earlier, many utilities fall
in this range.
Beta of 1 - A beta of 1 represents the volatility of the
given index used to represent the overall market, against
which other stocks and their betas are measured.
The S&P 500 is such an index. If a stock has a beta of
one, it will move the same amount and direction as the
index. So, an index fund that mirrors the S&P 500 will
have a beta close to 1.
Beta greater than 1 - This denotes a volatility that is Variance is calculated by taking the differences between
greater than the broad-based index. Again, as we each number in the set and the mean, squaring the
mentioned above, many technology companies on the differences (to make them positive) and dividing the sum
Nasdaq have a beta higher than 1. of the squares by the number of values in the set
Formula of Variance:
Beta greater than 100 - This is impossible, as it
essentially denotes a volatility that is 100 times greater
than the market. If a stock had a beta of 100, it would be
expected to go to 0 on any decline in the stock market. If Example
you ever see a beta of over 100 on a research site it is Year Return
usually the result of a statistical error, or the given stock 1 10%
has experienced large swings due to low liquidity, such
as an over-the-counter stock. For the most part, stocks 2 20%
of well-known companies rarely ever have a beta higher 3 -15%
than 4. Find the average of 3 returns
(10%) + (20%) + (-15%) = 5%
How to Calculate Beta Computation:
To calculate the beta of a security, =(10% - 5%)² + (20% - 5%)² + (-15% - 5%)² / 3
the covariance between the return of the security and =(5%)² + (15%)² + (-20%)² / 3
the return of market must be known, as well as = 25% + 225% + 400% / 3
the variance of the market returns. = 650% / 3 = 216.67%
Covariance measures how two stocks move together. A =√216.67%
positive covariance means the stocks tend to move = 14.72%
together when their prices go up or down. A negative Note: when calculating a sample variance to estimate a
covariance means the stocks move opposite of each population variance, the denominator of the variance
other. equation becomes N-1.
Variance, on the other hand, refers to how far a stock Sharpe Ratio
moves relative to its mean. For example, variance is - The sharpe ratio was developed by Nobel
used in measuring the volatility of an individual stock's Laureate William sharpe.
price over time. Covariance is used to measure the - The sharpe ratio measures risk-adjusted
correlation in price moves of two different stocks. performance. It is calculated by subtracting the risk free
The formula for calculating beta is the covariance of the rate of return (U.S treasury Bond) from the rate of return
return of an asset with the return of for an investment and dividing the results by the
the benchmark divided by the variance of the return of investments standard deviation of its return.
the benchmark over a certain period. Formula :
S = rp-rf
Op
Where :
Similarly, beta could be calculated by first dividing the Expected Portfolio Return (Rp) - the return measured
security's standard deviation of returns by the can be frequency (Daily, weekly, monthly or annually) as
benchmark's standard deviation of returns. The resulting long as they normally distributed. "Not all asset returns
value is multiplied by the correlation of the security's are normally distributed."
returns and the benchmark's returns. Risk Free Rate (Rf) - it is used to see if you are being
properly compensated for the additional risk you are
taking on with the asset. Rf is the shortes dated
government T-bills.
Portfolio Standard Deviation (Op) - a quantity
calculated to indicate the extent of deviation for a group
as whole.
Problem Example: If I have Investment of 15% for 3
Standard Deviation and Variance years, 5% risk free rate of investment and 20% Standard
Standard deviation can be defined in two ways: Deviation expected for a year. Calculate the SR using
1. A measure of the dispersion of a set of data from its formula.. :) (Basic Example )
mean. The more spread apart the data, the higher the SR = 15%-5%
deviation. Standard deviation is calculated as the square 20%
root of variance. = 10%
2. In finance, standard deviation is applied to the annual 20%
rate of return of an investment to measure the = 0.5 %
investment's volatility. Standard deviation is also known
as historical volatility. Note : The highest sharpe ratio the better :)
Variance (σ 2) is a measure of the dispersion of a set of
data points around their mean value.