Valuation and Investment

Banking
Unit – II
PREMALATHA K P
Introduction
• Investments
employment of funds in expectation of a future return.
• Risk
• The possibility of variance of actual return from the expected return or
degree of variability in the expected return.
• Elements of risk
• Systematic risk
• Unsystematic risk
Elements of Risk
• Systematic risk
• risk attributed to broad market factors
• Interest rate changes, political factors etc
• uncontrollable
• Unsystematic risk
• risk that can be described as the uncertainty inherent in a company or
industry investment.
• Business risk, financial risk, credit risk etc.
• controllable
Measurement of risk / quantifying of risk
• Mean variance method
• Used to measure total risk.
• Variance and std. deviations are the measures.
• Correlation / regression method
• Measures the systematic risk denoted as beta
• Correlation coefficient and std. deviations are used.
Pricing of risk
• Price risk is the risk that the value of a security or
investment will decrease. Factors that affect price risk include
earnings volatility, poor business management, and price
changes.
• Steps
• Know the risk
• Create a risk pricing plan
• Negotiate the risk
Methods of computing the risk
1. Standard deviation
2. Sharpe ratio
3. Beta
4. Value at risk
5. Conditional value at risk
6. R squared
Contd..

1. Standard deviation
It’s a measure from the data deviates its expected return.
Ex – a stock with higher SD experiences greater volatility and hence higher
level of risk.

2. Sharpe ratio
The Sharpe ratio compares the return of a investment with its risk. The
Sharpe ratio divides a portfolio's excess returns by a measure of its volatility
to assess risk-adjusted performance.
Contd..
3. Beta
it measures the sum of systematic risk of an individual
security or asset against the whole stock market.
A beta greater than 1.0 suggests that the stock is more volatile
than the broader market, and a beta less than 1.0 indicates a
stock with lower volatility.
Contd..
4. Value at risk
Value at risk (VaR) is a statistic that quantifies the extent of
possible financial losses within a firm, portfolio, or position over a
specific time frame. A financial firm.
Example, 3% one-month VaR of 2%, represents an 3% chance
of the asset declining in value by 2% during the one-month time
frame.
Contd..
5. Conditional value at risk
Conditional value-at-risk (CVaR) is the extended risk measure of value-at-
risk that quantifies the average loss over a specified time period of unlikely
scenarios beyond the confidence level.
For example, a one-day 99% CVaR of $12 million means that the expected
loss of the worst 1% scenarios over one-day period is $12 million.
CVaR is also known as expected shortfall.
Contd..
6. R squared
It’s a statistical evaluation to represent the percentage of a fund
portfolio or a security’s movements which can be shown by
movements of benchmark index.
It ranges from 0 to 100. value between 85 to 100 shows close
correlation whereas 70 or less than 70 shows less correlation.