Defined-Benefit vs.

Defined-Contribution Plans

Defined-benefit plan—also commonly known as a traditional pension plan

—provides a specified payment amount in retirement. A defined-contribution plan
allows employees to contribute and invest in funds and other securities over time
to save for retirement.
A 401(k) plan is a defined-contribution plan offered to employees of private
sector companies and corporations.
A 403(b) plan is very similar, but it is provided by public schools, colleges,
universities, churches, and charities.

Types of Risk characteristics

Risk-neutral - investor only looks at the potential gains of each investment

and ignores the potential downside risk. In other words, risk-neutral mainly focus
on how much money they will earn. If it maintains them, they can take risks. For
example, you offer 2 ways to a risk-neutral investor: less risky and normal return;
fantastic return with high risk. They will choose the second option most probably
because if the return is quite enough, they ignore the risk. Actually, this type of
investments are not so common. Investors mainly are risk-averse or risk-seeking.

Note: In investing, risk equals price volatility. A volatile investment can

make you rich or devour your savings.

Risk aversion – is the tendency to avoid risk and have a low risk tolerance.
Risk-averse investors prioritize the safety of principal over the possibility of a
higher return on their money. That is, their money can be accessed when needed,
regardless of market conditions at the moment. Risk-averse investors typically
invest their money in savings accounts, certificates of deposit (CDs), municipal
and corporate bonds, and dividend growth stocks. They regularly pay their
investors a dividend. They want their investments to be highly liquid. That is, that
money must be there in full when they're ready to make a withdrawal. No waiting
for the markets to swing up again. The greatest number of risk-averse investors can
be found among older investors and retirees.
One way is through diversification of your portfolio. Diversification means
including assets and asset classes that are not highly correlated with one another.
This way you are not putting all of your eggs into one basket, and if some
securities fall in a given day, others may rise to offset those individual losses.
Mathematically, diversification allows you to maximize your expected return while
minimizing your overall portfolio risk.
Investing in low-risk products like fixed-income securities can also mean
guaranteed cash flows and constant positive returns over time.
Risk-seeking – is one's acceptance of greater risk. Risk seekers are more
interested in capital gains from speculative assets than capital preservation from
lower-risk assets. Risk-seeking can be contrasted with risk-averse.
 Examples of asset types that might attract a risk-seeking investor include
options, futures, currencies, penny stocks, alternative investments,
cryptocurrencies, and emerging market equities.
Risk-seeking might also describe entrepreneurs who are willing to give up
the stability of salaried employment at an established company to start their own
companies in the hope of a greater financial and emotional payoff.
To be successful in these strategies requires investors to be well-educated in
trade execution and research. Investors need to monitor these investments closely
and be able to develop an exit strategy to preserve capital and gains.

Diversification in Business

Diversification is a risk management strategy that creates a mix of various

investments within a portfolio. A diversified portfolio attempts to limit exposure to
any single asset or risk. The rationale behind this technique is that a portfolio
constructed of different kinds of assets will, on average, yield higher long-term
returns and lower the risk of any individual holding or security.
Diversification is a strategy that mixes a wide variety of investments within
a portfolio in an attempt to reduce portfolio risk.
Diversification is most often done by investing in different asset classes such
as stocks, bonds, or real estate.
Diversification can also be achieved by purchasing investments in different
countries, industries, sizes of companies, or term lengths for income-generating
investments.
The quality of diversification in a portfolio is most often measured by
analyzing the correlation coefficient of pairs of assets.
Studies and mathematical models have shown that maintaining a well-
diversified portfolio of 25 to 30 stocks yields the most cost-effective level of risk
reduction. Investing in more securities generates further diversification benefits,
but it does so at a substantially diminishing rate of effectiveness.

Diversification Strategies:

Asset Classes - fund managers and investors often diversify their

investments across asset classes and determine what percentages of the portfolio to
allocate to each: stocks, bonds, real estate, cash and short-term cash-equivalents,
etc.
Please note that, what may negatively impact one asset class may benefit
another. For example, rising interest rates usually negatively impact bond prices as
yield must increase to make fixed income securities more attractive. On the other
hand, rising interest rates may result in increases in rent for real estate or increases
in prices for commodities.
 Industries/Sectors - here are tremendous differences in the way different
industries or sectors operate. As investors diversify across various industries, they
become less likely to be impacted by sector-specific risk. For example, consider
two major means of entertainment: travel and digital streaming. Investors hoping
to hedge against the risk of future major pandemic impacts may invest in digital
streaming platforms. At the same time, they may consider investing in airlines. In
theory, these two unrelated industries may minimize overall portfolio risk.
Corporate Lifecycle Stages (Growth vs. Value) - public equities tend to be
broken into two categories: growth stocks and value stocks. Growth stocks are
stocks in companies that are expected to experience profit or revenue growth
greater than the industry average. Value stocks are stocks in companies that appear
to be trading based on the current fundamentals of a company. Growth stocks tend
to be more risky as the expected growth of a company may not materialize. On the
other hand, value stocks tend to be more established, stable companies. By
diversifying into both, an investor would capitalize on the future potential of some
companies.

Present Value

Present value states that an amount of money today is worth more than the
same amount in the future. In other words, present value shows that money
received in the future is not worth as much as an equal amount received today.
Unspent money today could lose value in the future by an implied annual rate due
to inflation or the rate of return if the money were invested.
Receiving $1,000 today is worth more than $1,000 five years from now.
Why? Because an investor can invest that $1,000 today and presumably earn a rate
of return over the next five years. Present value takes into account any interest rate
an investment might earn. For example, if an investor receives $1,000 today and
can earn a rate of return of 5% per year, the $1,000 today is certainly worth more
than receiving $1,000 five years from now. If an investor waited five years for
$1,000, there would be an opportunity cost or the investor would lose out on the
rate of return for the five years.

Inflation Reduces Future Value

Inflation is the rise in prices of goods and services over time. If you receive
money today, you can buy goods at today's prices. As inflation causes the price of
goods to rise in the future, your purchasing power decreases. Consequently, money
that you don't spend today could be expected to lose value in the future by some
implied annual rate (which could be the inflation rate or the rate of return if the
money were invested).
 Determining the Discount Rate

The discount rate is the investment rate of return that is applied to the
present value calculation. In other words, the discount rate would be the rate of
return if an investor choose to accept an amount in the future versus the same
amount today. The discount rate that is chosen for the present value calculation is
highly subjective because it's the expected rate of return you'd receive if you had
invested today's dollars for a period of time.

Present Value Formula and Calculation

FV
Present Value = ( 1+ r ) n

FV – future value;
r – interest rate;
n(power) – number of periods(mainly years). Input the time period as the
exponent "n" in the denominator. So, if you want to calculate the present value of
an amount you expect to receive in three years, you would plug in the number
three.

Benefits of Present Value

Present value can be helpful to investors' and companies' financial and

investment decision-making. It can provide valuable insight into whether or not to
make certain investments over others. Present value can clarify whether an
investment's estimated rate of return is enough to make the future result of the
investment worthwhile. In addition, it can serve as a fundamental comparison tool
during the investment selection process. Understanding the meaning of present
value and employing its formula can shed light on the economic impact of the
changing value of money across high inflation periods.

Example of Present Value

Let's say you have the choice of being paid $2,000 today earning 3%
annually or $2,200 one year from now. Which is the best option?
Using the present value formula, the calculation is $2,200 / (1 + 0.03) 1 =
$2,135.92
PV = $2,135.92. So, if you were paid $2,000 today and it could earn a 3%
interest rate, but the amount would not be enough to give you $2,200 one year
from now.
 Future Value vs. Present Value

Future value is the value of a current asset at a specified date in the future
based on an assumed rate of growth. The FV calculation allows investors to
predict, with varying degrees of accuracy, the amount of profit that can be
generated by different investments.
Present value is the current value of a future sum of money. Present value
takes the future value and applies a discount rate or the interest rate that could be
earned if invested. Future value tells you what an investment is worth in the future
while the present value tells you how much you'd need in today's dollars to earn a
specific amount in the future.

How Do You Calculate Present Value?

Present value is calculated by taking the future cash flows expected from an
investment and discounting them back to the present day. To do so, the investor
needs three key data points: the expected cash flows, the number of years in which
the cash flows will be paid, and their discount rate. The discount rate is a very
important factor in influencing the present value, with higher discount rates leading
to a lower present value, and vice-versa. Using these variables, investors can
calculate the present value using the formula:

FV
Present Value = ( 1+ r ) n

*n is power.

What Is An Example of Present Value?

Consider a scenario where you expect to earn a $5,000 lump sum payment in
five years' time. If the discount rate is 8.25%, you want to know what that payment
will be worth today. So you calculate the PV: $5,000/(1 + 0.0825)5 = $3,363.80.

Why Is Present Value Important?

Present value is important because it allows investors to judge whether or

not the price they pay for an investment is appropriate. Present value calculations
are often needed in areas such as investment analysis, risk management, and
business financial planning, but the concept is also useful outside of business. For
example, understanding the present and future values of an annuity can help you
when predicting your retirement income.
 The Bottom Line

Present value is a way of representing the current value of future cash flows,
based on the principle that money in the present is worth more than money in the
future. Present value is used to value the income from loans, mortgages, and other
assets that may take many years to realize their full value. Investors use these
calculations to compare the value of assets with very different time horizons.

Financial Exposure

Financial exposure refers to the risk inherent in an investment, indicating the

amount of money an investor stands to lose. Experienced investors usually seek to
optimally limit their financial exposure which helps maximize profits. Asset
allocation and portfolio diversification are broadly used strategies for managing
financial exposure. Knowing and understanding financial exposure, which is an
alternative name for risk, is a crucial part of the investment process.
For instance, if 100 shares of stock purchased at $10 a share appreciated to
$20, selling 50 shares would eliminate the financial exposure. The original
purchase cost the investor $1,000. As the shares appreciate, selling 50 shares at $20
returns the investor's initial stake. The only one risk would be for the profit because
investor has already compensated the principal amount($1.000). Conversely, if the
stock decreased from the original purchase price of $10 to $5 per share, the
investor would have lost half the original principal amount.
Financial exposure applies not only to investing in the stock market but
exists whenever an individual stands to lose any of the principal value spent.
Purchasing a home is an excellent example of financial exposure. If the value of
real estate declines and the homeowner sells at a lower price than the original
purchase price, the homeowner recognizes a loss on the investment.

Reducing Financial Exposure

The simplest way to minimize financial exposure is to put money into

principal-protected investments with little to no risk. Certificates of deposit (CDs)
or savings accounts are two ways to reduce financial exposure drastically.
However, with no risk, an investment provides little return. Also, if there is little
financial exposure, this leaves a conservative investor vulnerable to other risks
such as inflation.
Another way to reduce financial exposure is to diversify among many
investments and asset classes. To build a less volatile portfolio, an investor should
have a combination of stocks, bonds, real estate, and other various asset classes.
 Hedging is another way to reduce financial exposure. There are many ways
to hedge a portfolio or an investment. An investor can hedge in the stock market by
using options.

What Is an Example of Financial Exposure?

Financial exposure is the potential loss of the total amount invested. For
example, if an individual invests $2,000 into a stock, their financial exposure is
$2,000, and if the stock drops, they could lose the entire $2,000 value.

Risk Exposure

Risk exposure is the quantified potential loss from business activities

currently underway or planned. The level of exposure is usually calculated by
multiplying the probability of a risk incident occurring by the amount of its
potential losses. Risk exposure in business is often used to rank the probability of
different types of losses and to determine which losses are acceptable or
unacceptable. Losses may include legal liability, property loss or damage,
unexpected employee turnover, changes in demand, payment of ransom to
cybercriminals, or other activity that could result in either a profit or a loss for the
business. The objective of the risk exposure calculation is to help determine the
overall level of risk the organization can tolerate based on the benefits and costs
involved. The level of risk an organization is prepared to accept to achieve its goals
is called its risk appetite.

What are the different categories and types of risk exposure?

There are two primary categories of risk exposure: pure risk and speculative
risk.
Pure risk exposure – is a risk that cannot be wholly foreseen or controlled,
such as a natural disaster or global pandemic that impacts an organization's
workforce. Most organizations are exposed to at least some pure risks, and
preemptive controls and processes can be created that minimize loss, to some
degree, in these pure risk circumstances.
Speculative risk – is a type of risk that occurs based on actions an
organization takes and their subsequent consequences. Examples of speculative
risk might be the choice of a software platform that is later susceptible to critical
vulnerabilities or a choice to keep all backups on-site, which are later infected by
ransomware.
There are many different types of risk exposure, but the most common
include the following:
 Brand damage. Organizations incur brand damage when the image of the
brand is undermined or made obsolete by events. These events range from
customer service failures to outages, breaches or other types of cybersecurity
issues.
Compliance failures. Compliance risk is an organization's potential exposure
to legal penalties, financial forfeiture and material loss, resulting from its failure to
act in accordance with industry laws and regulations, internal policies or prescribed
best practices.
Security breaches. Security breaches are significant avenues of risk
exposure, especially if sensitive stolen data is posted online for others to access.
Liability issues. Organizations can be liable legally for a wide range of
transgressions. These could include cybersecurity issues like breaches, data
exposure, failure to meet service-level agreements and many more.

How do you calculate risk exposure?

To calculate risk exposure, analysts often use an equation similar to this:

Risk exposure = probability of risk occurring x total loss of risk occurrence

For example, an organization might have a 50% likelihood of being hit by

ransomware (0.5 probability); the impact is determined as $2 million in recovery,
consulting fees and loss of revenue (this is a complicated metric for impact). In a
simple risk exposure equation, this would work out to:

Risk exposure = risk impact ($2,000,000) x probability (0.5)

Risk exposure = $1,000,000

How do you manage risk exposure?

The following techniques and tactics are commonly used by organizations to

manage risk exposure:
Risk avoidance. Organizations can alter choices and decisions to avoid risky
activities.
Risk mitigation. Controls and processes can be implemented that help
mitigate and minimize risk in many different areas.
Risk transfer. Through insurance and third-party service arrangements,
organizations can transfer some risk to outside parties.
Risk retention. Organizations can always choose to accept risk and
accommodate it as part of ongoing operations.
 Standard Deviation Used to Determine Risk

Risk measurement is a very big component of many sectors of the finance

industry. The impact of it, is most clearly illustrated in the investment sector.
Traders and analysts use a number of metrics to assess the volatility and relative
risk of potential investments, but one of the most common metric is standard
deviation.
Standard deviation helps determine market volatility or the spread of asset
prices from their average price. When prices move wildly, standard deviation is
high, meaning an investment will be risky. Low standard deviation means prices
are calm, so investments come with low risk.
While standard deviation is an important measure of investment risk, it is not
the only one. There are many other measures investors can use to determine
whether an asset is too risky for them—or not risky enough.

Calculating Standard Deviation

Standard deviation is calculated by first subtracting the mean from each

value, and then squaring, adding, and averaging the differences to produce the
variance.
For stock prices, the original data is in dollars and variance is in dollars
squared, which is not a useful unit of measure. Standard deviation is simply the
square root of the variance, bringing it back to the original unit of measure and
making it much simpler to use and interpret.
The formula for the SD requires a few steps:
1. First, take the square of the difference between each data point and the
sample mean, finding the sum of those values.
2. Next, divide that sum by the sample size minus one, which is the variance.
3. Finally, take the square root of the variance to get the SD.

Relating Standard Deviation to Risk

Risk is not necessarily a bad thing in the investment world. The riskier the
security, the greater potential it has for payout.
When using standard deviation to measure risk in the stock market, the
underlying assumption is that the majority of price activity follows the pattern of a
normal distribution. In a normal distribution, individual values fall within one
standard deviation of the mean, above or below, 68% of the time. Values are within
two standard deviations 95% of the time.
For example, in a stock with a mean price of $45 and a standard deviation of
$5, it can be assumed with 95% certainty the next closing price remains between
$35 and $55. However, price plummets or spikes outside of this range 5% of the
time. A stock with high volatility generally has a high standard deviation.
 Because investors are most often concerned with only losses when prices fall
as a measure of risk, the downside deviation is sometimes employed, which only
looks at the negative half of the distribution.

How Are Standard Deviation and Variance Related?

The standard deviation is the square root of the variance. By taking the
square root, the units involved are effectively standardizing the spread between
figures in a data set around its mean. As a result, you can better compare different
types of data using different units in standard deviation terms. The greater the
standard deviation, the greater the investment's volatility(oynaklığı).

Example of Calculation

Applying standard deviation will show up how much an investment prices

gone up or drop in the past. Therefore, it helps us evaluating future outcomes.
For example, we’re trying to analyze the return we should follow five
periods of the following stock returns: 2% January, 7.5% in February, 1% next
month, 6% in April and 1.5% in May. First of all, we should find an average of
them: 2%+7.5%+1%+6%+1.5% = 18%/(5%) = 3.6% average historical return.
Then, (3.6%-2%)2+(3.6%-7.5%)2+(3.6%-1%)2+(3.6%-6%)2+(3.6%-1.5%)2 = 34.7 /
(5-1) = √8.675 = 2.9

Fat-tailed vs Normal distribution

Compared to fat-tailed distributions, in the normal distribution, events that

deviate from the mean by five or more standard deviations ("5-sigma events") have
lower probability, meaning that in the normal distribution extreme events are less
likely than for fat-tailed distributions.
Extreme events in risk management refer to events that have a low
probability of occurring but can have significant consequences when they occur.
Extreme events can manifest in various forms and contexts, and their impact can
be catastrophic, causing substantial financial losses, operational disruptions, or
damage to assets and infrastructure. Here are some examples of extreme events in
different domains:

1. Financial Markets - market crashes, sudden and sharp declines in asset

prices, or systemic events such as banking crises or sovereign debt defaults. These
events can lead to significant losses for investors, financial institutions, and the
broader economy.
 2. Natural Disasters - hurricanes, earthquakes, tsunamis, floods, and
wildfires are examples of extreme events with potentially devastating
consequences.
3. Operational Risks - large-scale cyberattacks, industrial accidents, supply
chain disruptions, or major technology failures. These events can lead to business
interruptions, reputational damage, regulatory penalties, and financial losses for
organizations.
4. Health Emergencies - pandemics or epidemics represent extreme events
with widespread health, social, and economic impacts.
5. Environmental Risks - extreme weather events, climate-related disasters,
and environmental catastrophes such as oil spills or nuclear accidents represent
extreme events in environmental risk management.
Managing extreme events includes conducting scenario analyses, stress
testing, and scenario planning to assess the impact of extreme events on
organizations and develop strategies to mitigate their risks.

Risk Thresholds

A quantified parameter or limit which risk can be taken or managed. The

collective name for risk appetite, risk tolerance and risk bearing capacity.
Successful risk management hinges on an organization’s ability to gauge its risk
thresholds and to work within the limits established by those thresholds. Risk
thresholds are benchmarks, and indicate how much risk the organization is
required to assume.
Risk thresholds assist to align the departmental priorities and to allocate
resources in accordance to efficiently and economically deliver on set priorities.
The taking, managing and reporting on risk in the department should be guided by
the frame of risk thresholds. They should help the Accounting Officer to decide
how much risks should be assumed and guided. The accounting officer, in
consultation with the chief risk officer, should establish risk thresholds that guide
the department’s taking and management of risks.
Determining the risk threshold requires interviews and meetings with the
stakeholders. This is necessary to find out about what their risk appetites are.
Based on their risk appetite, the project manager should analyze the risk tolerance
first before calculating the threshold.
The accounting officer should ensure that set goals and objectives meet the
SMART principle. This principle is discussed in detailed in the Strategic Plan and
Annual Performance Plan Framework. Thus, where the objective is, for example,
to build twenty houses it is essential that a ‘house’ is defined in terms of quality
and livability. In managing risk, specifications should be understood and agreed by
all parties from the beginning.
 Daily Returns

Daily returns refer to the percentage change in the value of an asset or

investment over a single trading day. They are calculated by comparing the closing
price of the asset on a given day to its closing price on the previous trading day(or
just opening price). Daily returns are widely used in finance and investment
analysis to measure the performance and volatility of assets, assess risk, and make
investment decisions. Here's how daily returns are typically calculated:

1. Calculate Price Change: First, determine the price change of the asset
from the previous day's closing price(today’s opening price) to the current day's
closing price. This is calculated as:

Price Change = Today’s Closing Price − Yesterday’s Closing Price

or
Price Change = Closing Price − Starting Price

2. Calculate Daily Return: Next, calculate the daily return as a percentage of

the previous day's closing price. This is calculated as:

Price Change
Daily Return ¿ ' ' x 100%
Yesterday s Closing Price(Today s opening price)

Daily returns provide insight into the day-to-day price movements of an

asset and are used to analyze its performance over time. Positive daily returns
indicate an increase in the asset's value from the previous day, while negative daily
returns indicate a decrease in value. By analyzing the distribution of daily returns
over a historical period, investors can assess the volatility and risk associated with
an asset and make informed decisions regarding portfolio management, trading
strategies, and risk mitigation.
For example, to illustrate, let's say you own 100 shares of XYZ stock. The
day opens at $20 and closes at $25. This is a $5 positive difference. Multiply the $5
difference by the 100 shares you own, for a daily return of $500.
Some investors will prefer to work in percentages rather than dollar
amounts. This is only slightly more complicated. You perform the same first step
and arrive at a $5 gain per share for the day. You then divide by the opening price
of $25, leaving you with 0.2. Multiply by 100 to arrive at your daily return of 20%.
 Arbitrage - Free Valuation

Arbitrage-free valuation is the value of an asset or financial instrument based

solely on the real performance or cash flows that it generates. Arbitrage-free
valuation is valuing an asset without taking into consideration derivative or
alternative market pricing. It can be calculated for various types of assets using
financial formulas that account of all of the cash flows generated by an asset.

Applications of Arbitrage-Free Valuation

Arbitrage-free valuation is used in a couple of different ways. First, it can be

the theoretical future price of a security or commodity based on the relationship
between spot prices, interest rates carrying costs, exchange rates, transportation
costs, convenience yields, etc. Carrying costs are simply the cost of holding
inventory.
It can also be the theoretical spot price of a security or commodity based on
the futures price, interest rates, carrying costs, convenience yields, exchange rates,
transportation costs, etc. Convenience yield(Kolaylık getirisi), is when you hold on
to the actual physical good versus the liquid asset. An example would be holding
on to a barrel of oil versus holding on to an oil futures contract. When the actual
futures price does not equal the theoretical futures price, arbitrage profits may be
made.
Arbitrage is more useful for traders rather than investors.

Arbitrage-Free Valuation Example

Suppose that oranges that cost $1 a piece off the tree in Florida sell for $5 on
the street in New York City because they can only be grown in Florida (and
additional places where weather permits it). If the transportation, storage,
marketing, and other related costs to bring each orange to market from Florida to
New York come to $4, then in both places the respective market price ($1 in
Florida or $5 in New York) is equal to the arbitrage-free valuation of the orange
($1 to grow the orange in Florida vs. $1 to grow the orange + $4 in associated costs
to bring it to market in New York).
Now suppose that transportation costs fall due to technological improvement
or lower fuel prices, and as a result, the cost of bringing a Florida orange to market
in New York falls from $4 to $3. Now the arbitrage-free valuation of the orange in
New York is $4 ($1 cost to grow the orange in Florida and $3 to bring it to market
in New York).
Savvy businesspeople would take advantage of this and utilize the resulting
arbitrage to make money by buying oranges off the truck from Florida at the lower
price of $4 and re-selling them at $5. However as they do so, they will have to
compete against and against new orange resellers will be attracted into the market
by the arbitrage profit opportunity, by offering lower prices. This competition will
eventually drive the market price closer to its arbitrage-free valuation of $4.

Linear vs Non-linear instruments

Linear and non-linear instruments are terms used in finance to describe

different types of financial contracts or securities based on the relationship between
their payoffs and underlying variables. Here's an explanation of each:

1. Linear Instruments:
- Linear instruments have payoffs that are directly proportional to the change
in the underlying variables;
- The payoff of a linear instrument can be represented as a straight line when
plotted against the underlying variable.
Examples of linear instruments include:
Forward & Future contracts: The payoff of a forward contract is linear with
respect to the price of the underlying asset at maturity.

2. Non-linear Instruments:
- Non-linear instruments have payoffs that are not directly proportional to
the change in the underlying variables;
- The payoff of a non-linear instrument cannot be represented as a straight
line when plotted against the underlying variable.
Examples of non-linear instruments include:
Options with non-linear payoffs: Exotic options, such as barrier options,
Asian options, and rainbow options, have non-linear payoff structures that are
dependent on various factors such as the path of the volatility and time to
expiration.
Convertible bonds: Convertible bonds have non-linear payoffs because their
value is influenced by both the fixed-income characteristics of the bond and the
equity conversion feature.
In summary, linear instruments have payoffs that are directly proportional to
changes in the underlying variables and can be represented as straight lines, while
non-linear instruments have payoffs that are not directly proportional and exhibit
more complex payoff structures. Investors and traders use both linear and non-
linear instruments to hedge risk, speculate on market movements, and manage
their investment portfolios.

Risk-Free Rate of Return

 The risk-free rate of return is the theoretical rate of return of an investment
with zero risk. The risk-free rate represents the interest an investor would expect
from an absolutely risk-free investment over a specified period of time. The so-
called "real" risk-free rate can be calculated by subtracting the current inflation rate
from the yield of the Treasury bond(xəzinə istiqrazının gəlirindən) matching your
investment duration. Investors won't accept risk greater than zero unless the
potential rate of return is higher than the risk-free rate. In practice, the risk-free rate
of return does not truly exist, as every investment carries at least a small amount of
risk. In theory, the risk-free rate is the minimum return an investor expects for any
investment. Different countries and economic zones use different benchmarks as
their risk-free rate.

Negative Interest Rates

Negative interest can exist in certain economic climates; this can complicate
calculating the risk-free rate o f return and its impact on investors. In Japan,
stubborn deflation has led the Bank of Japan to pursue a policy of ultra-low, and
sometimes negative, interest rates to stimulate the economy. Negative interest rates
essentially push the concept of risk-free return to the extreme; investors are willing
to pay to place their money in an asset they consider safe.

Why is the risk-free rate is important?

It’s important to economists and financial institutions because they use it as

the starting point of calculating the cost of equity and capital.

Risk factors are characteristics at the biological, psychological, family,

community, or cultural level that precede and are associated with a higher
likelihood of negative outcomes.
Protective factors are characteristics associated with a lower likelihood of
negative outcomes or that reduce a risk factor’s impact.
Some risk and protective factors are fixed: they don’t change over time.
Other risk and protective factors are considered variable and can change over time.
Variable risk factors include income level or employment status.

Variance

The term variance refers to a statistical measurement of the spread between

numbers in a data set. More specifically, variance measures how far each number
in the set is from the mean (average). Variance is often depicted by this symbol
sigma squared: σ2. It is used by both analysts and traders to determine volatility
and market security. Investors use variance to see how much risk an investment
carries and whether it will be profitable. Variance is also used in finance to
compare the relative performance of each asset in a portfolio to achieve the best
asset allocation. In statistics, variance measures variability from the average or
mean. It 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 minus one in the data set.
In finance, Variance used to determine volatility and market security. Also, it
is also used to compare the relevant performances of each assets in a portfolio to
find the best allocation.

Advantages and Disadvantages of Variance

Statisticians use variance to see how individual numbers relate to each other
within a data set. The advantage of variance is that it treats all deviations from the
mean as the same regardless of their direction. One drawback to variance, though,
is that it gives added weight to outliers. These are the numbers far from the mean.
Squaring these numbers can skew the data.

How Do I Calculate Variance

Follow these steps to compute variance:

1. Calculate the mean of the data.

2. Find each data point's difference from the mean value.
3. Square each of these values.
4. Add up all of the squared values.
5. Divide this sum of squares by n – 1 (for a sample).

Standard Deviation

Standard deviation is a statistic that measures the dispersion of a dataset

relative to its mean and is calculated as the square root of the variance. The
standard deviation is calculated as the square root of variance by determining each
data point's deviation relative to the mean. If the data points are further from the
mean, there is a higher deviation within the data set; thus, the more spread out the
data, the higher the standard deviation. Standard deviation, in finance, is often used
as a measure of a relative riskiness of an asset. A volatile stock has a high standard
deviation, while the deviation of a stable blue-chip stock is usually rather low.
When applied to the annual rate of return of an investment, standard deviation
sheds light on that investment's historical volatility. Standard deviation is
symbolized with sigma: σ. It shows the consistency of return in investment.

Calculating standard deviation

Standard deviation is calculated as follows:

1. Calculate the mean of all data points. The mean is calculated by adding
all the data points and dividing them by the number of data points.
2. Calculate the variance for each data point. The variance for each data
point is calculated by subtracting the mean from the value of the data
point.
3. Square the variance of each data point (from Step 2).
4. Sum of squared variance values (from Step 3).
5. Divide the sum of squared variance values (from Step 4) by the number
of data points in the data set less 1.
6. Take the square root of the quotient (from Step 5).

Why Is Standard Deviation a Key Risk Measure?

Standard deviation is an especially useful tool in investing and trading

strategies as it helps measure market and security volatility—and predict
performance trends. A lower standard deviation isn't necessarily preferable. It all
depends on the investments and the investor's willingness to assume risk. When
dealing with the amount of deviation in their portfolios, investors should consider
their tolerance for volatility and their overall investment objectives.
Standard deviation is one of the key fundamental risk measures that analysts,
portfolio managers, and advisors use. Investment firms report the standard
deviation of their mutual funds and other products. A large dispersion shows how
much the return on the fund is deviating(kənara çıxdığı) from the expected normal
returns. Because it is easy to understand, this statistic is regularly reported to the
end clients and investors.

Important: The standard deviation is graphically depicted as a bell curve

width around the mean of a data set. The wider the curve, the larger a data set's
standard deviation from the mean.

Strengths of Standard Deviation

 Standard deviation is all-inclusive of observations. Each data point is
included in the analysis. Other measurements of deviation such as range only
measure the most dispersed points without consideration for the points in between.
Therefore, standard deviation is often considered a more robust, accurate
measurement compared to other observations.

Limitations of Standard Deviation

There are some downsides to consider when using standard deviation. The
standard deviation does not actually measure how far a data point is from the
mean. Instead, it compares the square of the differences.
Outliers have a heavier impact on standard deviation. This is especially true
considering the difference from the mean is squared, resulting in an even larger
quantity compared to other data points. Therefore, be mindful that standard
observation naturally gives more weight to extreme values.

What Does a High Standard Deviation Mean?

This indicates that the data observed is quite spread out around the mean. A
small or low standard deviation would indicate instead that much of the data
observed is clustered tightly around the mean.

What Does Standard Deviation Tell You?

Standard deviation describes how dispersed(dağınık) a set of data is. It

compares each data point to the mean of all data points, and standard deviation
returns a calculated value that describes whether the data points are in close
proximity or whether they are spread out. In a normal distribution, standard
deviation tells you how far values are from the mean.

How Do You Find the Standard Deviation Quickly?

If you look at the distribution of some observed data visually, you can see if
the shape is relatively skinny vs. fat. Fatter distributions have bigger standard
deviations. Alternatively, Excel has built in standard deviation functions depending
on the data set.

How investors use Standard Deviation?

 The standard deviation of, let’s say stock, tells investors how volatile that
stock is. To calculate it, you can consider past, let’s say 5 months’ rate of returns
and find out standard deviation. However, don’t forget that, it doesn’t always give
you exact information. Because sometimes an assets with constant income of past
months or year, can decrease sharply.

Standard Deviation vs. Variance

Key Differences

Standard deviation measures how far apart numbers are in a data set, the
spread between numbers in a data set. Variance, on the other hand, gives an actual
value to how much the numbers in a data set vary from the mean, the average
degree to which each point differs from the mean.
Standard deviation is the square root of the variance and is expressed in the
same units as the data set. Variance can be expressed in squared units or as a
percentage (especially in the context of finance).

Value at Risk (VaR)

Value at Risk (VaR) has been called the "new science of risk management,"
and is a statistic that is used to predict the greatest possible losses over a specific
time frame. Commonly used by financial firms and commercial banks in
investment analysis, VaR can determine the extent and probabilities of potential
losses in portfolios. Risk managers use VaR to measure and control the level of risk
exposure. VAR is determined by three variables: period, confidence level, and the
size of the possible loss. There are three methods of calculating Value at Risk
(VaR) including the Historical method, the Analytical method(variance-covariance
method), and the Monte Carlo simulation. Using the data provided by VaR
modeling, financial institutions can determine whether they have sufficient capital
reserves in place to cover losses.

Elements of Value at Risk (VaR)

The traditional measure of risk is volatility and an investor's main concern is

the odds of losing money. The VaR statistic has three components: a period, a
confidence level, and a loss amount or loss percentage, and can address these
concerns:
- What can I expect to lose in dollars with a 95% or 99% level of
confidence next month?
 - What is the maximum percentage I can expect to lose with 95% or 99%
confidence over the next year?
The questions include a high level of confidence, a period, and an estimate
of investment loss.

Expected Shortfall(ES)

Conditional Value at Risk (CVaR), also known as the Expected

Shortfall(ES), is a risk assessment measure that quantifies the amount of tail risk
an investment portfolio has. Expected Shortfall(ES) is derived by taking a
weighted average of the “extreme” losses in the tail of the distribution of possible
returns. Expected Shortfall(ES) is used in portfolio optimization for effective risk
management. Expected Shortfall(ES) is derived from the value at risk for a
portfolio or investment. The use of Expected Shortfall(ES) as opposed to just VaR
tends to lead to a more conservative approach in terms of risk exposure. The choice
between VaR and Expected Shortfall(ES) is not always clear, but volatile and
engineered investments can benefit from Expected Shortfall(ES) as a check to the
assumptions imposed by VaR.
Generally speaking, if an investment has shown stability over time, then the
value at risk may be sufficient for risk management in a portfolio containing that
investment. However, the less stable the investment, the greater the chance that
VaR will not give a full picture of the risks, as it is indifferent to anything beyond
its own threshold. Expected Shortfall(ES) attempts to address the
shortcomings(çatışmazlıqlarını) of the VaR model, which is a statistical technique
used to measure the level of financial risk within a firm or an investment portfolio
over a specific time frame. While VaR represents a worst-case loss associated with
a probability and a time horizon, Expected Shortfall(ES) is the expected loss if that
worst-case threshold is ever crossed(ən pis vəziyyət həddini keçdikdə). Expected
Shortfall(ES), in other words, quantifies the expected losses that occur beyond the
VaR breakpoint(ən pis vəziyyət həddini keçdikdə).

Expected Shortfall(ES) Formula

Since ES values are derived from the calculation of VaR itself, the
assumptions that VaR is based on, such as the shape of the distribution of returns,
the cut-off level used, the periodicity of the data, and the assumptions about
stochastic volatility, will all affect the value of ES. Calculating ES is simple once
VaR has been calculated. It is the average of the values that fall beyond the VaR:
V aR
1
E S=
1−c
∫ x p ( x ) dx
−1

where:
 p(x)dx = the probability density of getting a return with value “x”;
c = the cut-off point on the distribution where the analyst sets the VaR
breakpoint;
VaR = the agreed-upon VaR level.

Conditional Value at Risk and Investment Profiles

Safer investments like large-cap U.S. stocks or investment-grade bonds

rarely exceed VaR by a significant amount. More volatile asset classes, like small-
cap U.S. stocks, emerging markets stocks, or derivatives, can exhibit ES many
times greater than VaRs. Ideally, investors are looking for small ES. However,
investments with the most upside potential often have large ES.
History has many examples, such as Long-Term Capital Management which
depended on VaR to measure its risk profile, yet still managed to crush itself by not
properly taking into account a loss larger than forecasted by the VaR model. ES
would, in this case, have focused the hedge fund on the true risk exposure rather
than the VaR cutoff. In financial modeling, a debate is almost always going on
about VaR versus ES for efficient risk management.

Backtesting

Evaluating the effectiveness of a trading strategy by running it against

historical data. The underlying theory is that any strategy that worked well in the
past is likely to work well in the future, and conversely. It is beneficial to reserve a
time period of historical data for testing purposes. If backtesting works, traders and
analysts may have the confidence to employ it going forward. Backtesting allows a
trader to simulate a trading strategy using historical data to generate results,
analyze risk and profitability before risking any actual capital. A well-conducted
backtest that yields positive results assures traders that the strategy is likely to
yield profits when implemented in reality. In contrast, a well-conducted backtest
that yields suboptimal results will prompt traders to alter or reject the strategy.

Important: Particularly complicated trading strategies, such as strategies

implemented by automated trading systems, rely heavily on backtesting to prove
their worth, as they are too arcane(gizli) to evaluate otherwise. As long as a trading
idea can be quantified, it can be backtested.

The Ideal Backtesting Scenario

The ideal backtest chooses sample data from a relevant time period of a
duration that reflects a variety of market conditions. In this way, one can better
judge whether the results of the backtest represent a fluke or sound trading. The
historical data set must include a truly representative sample of stocks, including
those of companies that eventually went bankrupt or were sold or liquidated. The
alternative, including only data from historical stocks that are still around today,
will produce artificially high returns in backtesting.
A backtest should take into account all transaction costs, no matter how
insignificant; because these can accumulate over the backtesting period and greatly
affect the outlook for a strategy's profitability. Traders should ensure that their
backtesting software accounts for these costs.
Out-of-sample testing and forward performance testing provide further
confirmation regarding a system's effectiveness and can show a system's true
colors before real cash is on the line. A strong correlation between backtesting, out-
of-sample, and forward performance testing results is vital for determining the
viability of a trading system.

Example

Suppose you’re an analyst at an investment firm, and you’ve been asked to

backtest a strategy against a set of historical data given to you. The strategy
involves buying a stock if it hits a 90-day low. The first step in backtesting would
be choosing unbiased(tarafsız) historical data. You then apply the strategy to the
data and find that the strategy yielded a return of 150 basis points better than the
current strategy used by the company. The backtest helped to solidify the research
performed in creating the trading strategy. The investment firm can decide whether
the backtest is reason enough to employ the strategy.

Some Pitfalls(Tələlər) of Backtesting

For backtesting to provide meaningful results, traders must develop their

strategies and test them in good faith, avoiding bias as much as possible. That
means the strategy should be developed without relying on the data used in
backtesting.
That’s harder than it seems. Traders generally build strategies based on
historical data. They must be strict about testing with different data sets from those
they train their models on. Otherwise, the backtest will produce glowing results
that mean nothing.
Similarly, traders must avoid data dredging, in which they test a wide range
of hypothetical strategies against the same set of data, which will also produce
successes that fail in real-time markets because there are many invalid strategies
that would beat the market over a specific time period by chance.
One way to compensate for the tendency to data dredge or cherry-pick is to
use a strategy that succeeds in the relevant. If in-sample and out-of-sample
backtests yield similar results, then they are more likely to be proved valid.
 Stress Testing

A computer-simulated technique to analyze how banks and investment

portfolios would fare in drastic economic scenarios. Such testing helps gauge
investment risk and the adequacy of assets, as well as to help evaluate internal
processes and controls. Regulations require banks to carry out various stress-test
scenarios and report on their internal procedures for managing capital and risk.
Companies that manage assets and investments commonly use stress testing
to determine portfolio risk, then set in place any hedging strategies necessary to
mitigate against possible losses. Asset and liability matching stress tests are widely
used, too, by companies that want to ensure they have the proper internal controls
and procedures in place. Retirement and insurance portfolios are also frequently
stress-tested to ensure that cash flow, payout levels, and other measures are well
aligned.

Types of Stress Testing

Stress tests can use historical, hypothetical, or simulated scenarios:

Historical scenario, the business—or asset class, portfolio, or individual

investment—is run through a simulation based on a previous crisis.
Hypothetical stress test is generally more specific, often focusing on how a
particular company might weather a particular crisis. For example, a firm in
California might stress-test against a hypothetical earthquake or an oil company
might do so against the outbreak of war in the Middle East.
Simulated Stress Testing, as for the methodology for stress tests, Monte
Carlo simulation is one of the most widely known. This type of stress testing can
be used for modeling probabilities of various outcomes given specific variables.
Factors considered in the Monte Carlo simulation, for example, often include
various economic variables.

Advantages and Disadvantages of Stress Testing

Stress tests are forward-looking analytical tools that help financial

institutions and banks better understand their financial position and risks. They
help managers identify what measures to take if certain events arise and what they
should do to mitigate risks. As a result, they are better able to form action plans to
thwart threats and prevent failure. For investment managers, they are better able to
assess how well managed assets might perform during economic downturns. To
perform stress tests, financial institutions need to create the framework and
processes for which the tests can be performed. This restructuring is complex and
is often associated with costly mistakes. For example, it's possible that the test
scenario does not represent the types of risks a bank may face. This may be due to
insufficient data or the test designer's inability to create a relevant test. In the end,
the results of the test may lead to the creation of plans for events not likely to
occur. This misrepresentation can cause institutions to ignore the risks that are
possible.

Pros:

- Helps mitigate risks;

- Enables better financial planning;

- Highlights banks' or assets' strengths and weaknesses.

Cons:

- May produce unfavorable consequences;

- Is complex and costly to administer;

- May result in inadequate planning.

Example of Stress Testing

Banks and financial institutions often use the Federal Reserve's Dodd-
Franklin Act Stress Test (DFAST) and Comprehensive Capital Analysis and Review
(CCAR) stress test.
The Federal Reserve administers the Comprehensive Capital Analysis and
Review stress test annually for banks with at least $100 billion in assets. This test
identifies whether banks have sufficient capital to operate during economic
downturns and plans in place to address such events and other associated risks.
Specifically, the Federal Reserve looks at the bank's capital, its plans for its capital
(e.g., dividends), and how it assesses capital needs.

What Happens if You Fail a Stress Test?

If a company fails a stress test, it may be required to increase its capital

reserves to address threats. In the banking and financial services industry, some
failures result in fines or the prohibition of certain activities, such as paying
dividends.

The Bottom Line

 Stress tests can be effective analytical tools in identifying whether a
company has sufficient capital, strong assets, and effective plans to weather an
economic storm. Companies can use historical, hypothetical, or simulated events to
create test scenarios, or they may be required by a regulatory body to perform
certain tests. The results can help companies better understand their strengths,
weaknesses, and areas of opportunity.

Model Risk

Model risk is a type of risk that occurs when a financial model is used to
measure quantitative information such as a firm's market risks or value
transactions, and the model fails or performs inadequately and leads to adverse
outcomes for the firm. A model is a system, quantitative method, or approach that
relies on assumptions and economic, statistical, mathematical, or financial theories
and techniques. The model processes data inputs into a quantitative-estimate type
of output. While models can be useful tools in investment analysis, they can also
be prone to various risks that can occur from the usage of inaccurate data,
programming errors, technical errors, and misinterpretation of the model's
outputs.
In finance, models are used to identify potential future stock values and help
company managers make business decisions. Model risk can be reduced with
model management such as testing, governance policies, and independent review.
Model risk mostly affects the firm that creates and uses the model. Traders or other
investors who use a given model may not completely understand its assumptions
and limitations, which limits the usefulness and application of the model itself. A
model can incorrectly predict the probability of an airline passenger being a
terrorist or the probability of a fraudulent credit card transaction. This can be due
to incorrect assumptions, programming or technical errors, and other factors that
increase the risk of a poor outcome.

What Does the Concept of Model Risk Tell You?

Any model is a simplified version of reality and there is the risk that
something will fail to be accounted for. Assumptions made to develop a model and
inputs into the model can vary widely. The use of financial models has become
very prevalent(geniş) in the past decades, in step with advances in computing
power, software applications, and new types of financial securities. Before
developing a financial model, companies will often conduct a financial forecast,
which is the process by which it determines the expectations of future results.
Some companies, such as banks, employ a model risk officer to establish a
financial model risk management program aimed at reducing the likelihood of the
bank suffering financial losses due to model risk issues. Components of the
program include establishing model governance and policies. It also involves
assigning roles and responsibilities to individuals who will develop, test,
implement, and manage the financial models on an ongoing basis.

Real World Examples of Model Risk

JPMorgan Chase. Almost 15 years later, JPMorgan Chase (JPM) suffered

massive trading losses from a value at risk (VaR) model that contained formula and
operational errors. In 2012, CEO Jamie Dimon's proclaimed "tempest in a teapot"
turned out to be a $6.2 billion loss resulting from trades gone wrong in its synthetic
credit portfolio (SCP).
A trader had established large derivative positions that were flagged by the
VaR model that existed at the time. In response, the bank's chief investment officer
made adjustments to the VaR model, but due to a spreadsheet error in the model,
trading losses were allowed to accumulate without warning signals from the
model.
This was not the first time that VaR models have failed. In 2007 and 2008,
VaR models were criticized for failing to predict the extensive losses many banks
suffered during the global financial crisis.