Portfolio Theory and

Security Analysis
Chapter 3, Unit 1

Portfolio Theory and Security

Gagan Sawhney Fall 2020
Analysis
Portfolio Theory and Security Analysis

Table of Contents
1. Introduction .......................................................................................................................................... 2
2. Variance ................................................................................................................................................ 3
Understanding Variance ........................................................................................................................... 3
3. Semi-variance of return ........................................................................................................................ 4
4. Shortfall Probabilities ............................................................................................................................ 5
Summary ....................................................................................................................................................... 6
5. Value at Risk (VaR) ................................................................................................................................ 7
The Idea Behind VaR ................................................................................................................................. 7
6. Tail Value at Risk (Tail-VaR) and expected shortfall.............................................................................. 9

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Portfolio Theory and Security Analysis

Measures of Investment Risk

1. Introduction
In finance, the decisions regarding investment are made with two key factors in mind, i.e. ‘risk’
and ‘return’. Return is simple to measure and has one credible definition, however risk is a
different story. There are many ways to measure risk and, in this chapter, we discuss these
different measures of risk. following risk measures are discussed in this chapter:

1) Variance
2) Semi-variance
3) Shortfall Probability
4) Expected Shortfall
5) Conditional Expected Shortfall
6) Value at Risk, VaR
7) Tail VaR

Risk measures can be applied in several contexts. Insurance companies are interested in how
high claim liabilities might be. Banks care about profit and loss, specifically how large losses
might be. Investment professionals seek to describe the probability distribution of an individual
asset or portfolio of assets, and worry about return outcomes that may be especially low. In any
case, one must determine an amount of assets to set aside to protect against a specific adverse
outcome of the quantity of interest.

Risk measures are needed for both internal purposes, as within a corporate risk management
department that informs executives of exposure pockets, or for external purposes, as when
capital requirements must be satisfied for regulatory purposes. When designing risk
management products or policies, the analyst is most concerned with forecasting downside
risk, and thus needs to be able to quantify the probability of a particular negative outcome, or
the expected loss if it surpasses some negative threshold. One can address such issues by
relying on certain characteristics of the probability distribution used to describe the
phenomenon of interest.

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2. Variance
Variance, in statistics, is a measurement of the spread between numbers in a data set. That is, it
measures how far each number in the set is from the mean and therefore from every other
number in the set. In mean-variance portfolio theory, the most popular measure of risk is
variance or standard deviation, which can be employed in either an individual asset or a
portfolio context. In this chapter we are concerned only in the distribution of a single asset instead of
an entire asset portfolio.

Understanding Variance
Variance is calculated by taking the differences between each number in the data set and the
mean, then squaring the differences to make them positive, and finally dividing the sum of the
squares by the number of values in the data set.

The formula for variance is:

𝑉𝑎𝑟(𝑋) = 𝐸[(𝑋 − 𝜇)2 ] = 𝐸[𝑋 2 ] − 𝐸[𝑋]2 = 𝜎 2

Continuous Distribution Discrete Distribution

𝐸(𝑋 − 𝜇)2 = ∫ (𝑥 − 𝜇)2 𝑓(𝑥)𝑑𝑥 ∑ (X − μ)2 P[X = x]

𝑎𝑙𝑙 𝑥 all x

The expectation is calculated differently for the discrete distribution and the continuous
distribution. Correspondingly, the standard deviation is 𝑆𝐷[𝑋] = √𝑉𝑎𝑟(𝑋) = 𝜎. Naturally,
higher the value of 𝜎 2 , the more variable the asset’s return distribution is, and the riskier the
asset will be.

Variance has the advantage over most other measures in that it is mathematically tractable,
and the mean-variance framework discussed in a later chapter leads to elegant solutions for
optimal portfolios.

The mean-variance portfolio theory discussed in a later chapter assumes that investors base
their investment decisions solely on the mean and variance of investment returns.

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3. Semi-variance of return
The main argument against the use of variance as a measure of risk is that most investors
do not dislike uncertainty of returns as such; rather they dislike the possibility of low
returns.

Because we may only care about the downside risk rather than the upside variability when
designing risk management strategies, an alternative risk measure that provides such
information is semi-variance, which is also known as the downside semi-variance. Now, we
only look at what happens below the mean return, µ.

More specifically, let 𝜎 2 = 𝑉𝑎𝑟(𝑋) = 𝐸[(𝑋 − 𝜇)2 ], and then define the semi-variance as
𝜎 2 = 𝐸{[min(0, 𝑋 − 𝜇)]2 }. Thus, if X < µ (which is the case we care about), then X - µ< 0, and
min (0, X- µ) = X - µ.

However, if X ≥ µ, then X - µ ≥ 0, and min (0, X - µ) = 0.

The formulae for discrete and continuous distributions, are given by:

Continuous Distribution Discrete Distribution

𝐷𝑆𝑉 = ∫𝑥<𝜇(𝑥 − 𝜇)2 𝑓(𝑥)𝑑𝑥 𝐷𝑆𝑉 = ∑𝑥<𝜇(𝑥 − 𝜇)2 𝑃[𝑋 = 𝑥]

Where µ is the mean return.

Also note that the semi-variance must be non-negative, even though all of the terms in
min(0, 𝑥 − 𝜇) are non-positive due to squaring. Semi-variance is not easy to handle
mathematically, and it takes no account of variability above the mean. Furthermore, if returns
on assets are symmetrically distributed, semi-variance is proportional to variance.

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4. Shortfall Probabilities
Shortfall risk refers to the probability that a portfolio will not exceed the minimum (benchmark)
return that has been set by the investor. In other words, it is the risk that a portfolio will fall
short of the level of return considered acceptable by the investor. As such, shortfall risks are
downside risks.

A shortfall probability measures the probability of returns falling below a certain level. The
formulae for discrete and continuous distributions are given by:

Continuous Distribution Discrete Distribution

𝑆𝑃 = ∫𝑥<𝐿 𝑓(𝑥)𝑑𝑥 𝑆𝑃 = ∑ 𝑃[𝑋 = 𝑥]

𝑥<𝐿

where: L – chosen benchmark level

While shortfall risk focuses on the downside economic risk, the standard deviation measures
the overall volatility of a financial asset. Graphically, shortfall risk is depicted as:

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Summary
Measure Continuous Discrete

Variance ∑ (𝐗 − 𝛍)𝟐 𝐏[𝐗 = 𝐱]

𝐄(𝐗 − 𝛍)𝟐 = ∫ (𝐱 − 𝛍)𝟐 𝐟(𝐱)𝐝𝐱
𝐚𝐥𝐥 𝐱
𝐚𝐥𝐥 𝐱

Downside Semi ∑ (𝒙 − 𝝁)𝟐 𝑷[𝑿

Variance ∫ (𝒙 − 𝝁)𝟐 𝒇(𝒙)𝒅𝒙 𝒙<𝝁

𝒙<𝝁 = 𝒙]

Shortfall ∑ 𝐏[𝐗 = 𝐱]
Probability ∫ 𝐟(𝐱)𝐝𝐱 𝐱<𝐋

𝐱<𝐋
P[X<L]

Expected ∑ (𝐋 − 𝐱)𝐏[𝐗 = 𝐱]
Shortfall ∫ (𝑳 − 𝒙)𝒇(𝒙)𝒅𝒙 𝐱<𝐋

𝒙<𝑳
E[max(L-X,0)]

Conditional (∑ (𝑳 − 𝒙)𝑷[𝑿 = 𝒙])

𝒙<𝑳
Expected ( ∫(𝑳 − 𝒙)𝒇(𝒙)𝒅𝒙)/𝑷[𝑿 < 𝑳]
/𝑷[𝑿 < 𝑳]
Shortfall 𝒙<𝑳

E[L-X|X<L]

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5. Value at Risk (VaR)

The Idea Behind VaR
The most popular and traditional measure of risk is volatility. The main problem with volatility,
however, is that it does not care about the direction of an investment's movement: stock can
be volatile because it suddenly jumps higher. Of course, investors aren't distressed by gains.

For investors, the risk is about the odds of losing money, and VAR is based on that common-
sense fact. By assuming investors care about the odds of a really big loss, VAR answers the
question, "What is my worst-case scenario?" or "How much could I lose in a really bad
month?"

Often abbreviated by VaR, Value-at-Risk is defined based upon α, where α is the given
quantile or percentile. When using the value-at-risk measure, an analyst is interested in making
a statement of the following form:

“I am X percent certain there will not be a loss of more than V dollars in the next N days.”

The variable V is the VaR of the portfolio. It is a function of two parameters: the time horizon (N
days) and the confidence level (X%). It is the loss level over N days that has a probability of only
(100-X) % of being exceeded. When N days is the time horizon and X% is the confidence level,
VaR is the loss corresponding to the (100-X)th percentile of the distribution of the gain in the
value of the portfolio over the next N days.

VaR is an attractive measure because it is easy to understand. In essence, it asks the simple
question ‘‘How bad can things get?’’ This is the question all risk managers want answered.
Graphically VaR can be denoted as:

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Portfolio Theory and Security Analysis

For a continuous random variable, Value at Risk can be determined as:

𝑉𝑎𝑅(𝑅) = −𝑡 𝑤ℎ𝑒𝑟𝑒 𝑃(𝑅 < 𝑡) = (100 − 𝑋)%

Or a generic formula:

𝑃𝑟𝑜𝑏(𝑅𝑒𝑡𝑢𝑟𝑛 < 𝑉𝑎𝑅 𝐿𝑜𝑠𝑠) = 𝐶𝑜𝑛𝑓𝑖𝑑𝑒𝑛𝑐𝑒 𝐿𝑒𝑣𝑒𝑙(100 − 𝑋)%

Note that, when we look at the probability distribution of the gain, a loss is a negative gain and
VaR is concerned with the left tail of the distribution. When we look at the probability
distribution of the loss, a gain is a negative loss and VaR is concerned with the right tail of the
distribution.

Do note that the notation of VaR is different from Var (which is used to denote variance).

Downside of VaR
Even though VaR is a pretty useful statistical technique, it suffers from a few drawbacks:

▪ It fails to give an idea of the size of the loss related to the extreme data points or the tail
of the probability distribution.
▪ VAR is not additive. This means VAR of individual stocks does not equal to the VAR of
the total portfolio. It is because VAR does not consider correlations, and thus, adding
may result in double counting.
▪ Calculating VaR of a portfolio is a difficult task. One not only has to calculate the risk and
return of each security, but also correlations among them. So, if a portfolio has a
diversity of assets, the task to calculate VAR gets more difficult.
▪ To calculate VaR, one needs to make a few assumptions. If these assumptions are not
valid, then the VaR figure is inaccurate as well.

Advantages of VaR
▪ VaR value is a single digit, either as a percentage or in dollar terms. This makes it easy to
understand and interpret.
▪ Finance experts use this measure widely by. Moreover, it plays an important in role in
decision making as well.

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6. Tail Value at Risk (Tail-VaR) and expected shortfall

Whereas VaR asks the question ‘‘How bad can things get?’’, expected shortfall asks ‘‘If
things do get bad, how much can the company expect to lose?’’. A measure that deals with the
problem we have just mentioned is expected shortfall or Tail VaR.

The Tail Value-at-Risk, TVaR, of a portfolio is defined as the expected outcome (loss),
conditional on the loss exceeding the Value-at-Risk (VaR), of the distribution.

Mathematically, Tail-VaR could be defined as:

𝐿
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑆ℎ𝑜𝑟𝑡𝑓𝑎𝑙𝑙 = 𝐸[max(𝐿 − 𝑋, 0)] = ∫ (𝐿 − 𝑥)𝑓(𝑥)𝑑𝑥
−∞

where L is the chosen benchmark level.

If L is chosen to be a particular percentile point on the distribution, then the risk measure is
known as the Tail VaR.

Thus, while the VaR only determines where the “tail” of a distribution begins, the TVaR
quantifies the tail behavior.

A visual aid is required to understand why TVaR is required. Consider the following image:

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As we can see from the picture, when the distribution of returns is not normal VaR may not give
us the complete idea of the total potential loss. In both the portfolios, shown in the graphic,
VaR is same but the potential loss of portfolio 2 is much larger than portfolio 1.

The expected shortfall is the average amount the company loses over a 10-day period when the
loss is worse than the VaR.

References
(n.d.). Retrieved from https://www.investopedia.com/

Actuaries, I. a. (n.d.). CM2 Core Reading. IFoA.

Hull, J. C. (n.d.). Options, Futures and Other Derivatives. Pearson.

Toby A. White, F. C. (n.d.). MEASURES OF INVESTMENT RISK, MONTE CARLO SIMULATION,AND

EMPIRICAL EVIDENCE ON THE EFFICIENT MARKETS HYPOTHESIS. Society of Actuaries, USA.

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