1

FASTIP

Course: Risk
Management
Group project : Forecasting future return
of investment using Correlation, CAPM
and quantify a risk applying VaR
(simulation and the model building
approach) in the BKT
WORKED BY GROUP NR.5 :
ANA GIXHARI ,BESJANA MERA , JUNIOR GODO

Separated works : Ana Gixhari :Introduction and correlation; Besjana Mera: VAR
,model building approach and Var of portfolio ;Junior Godo : Capm and conclusion

TABLE OF CONTENTS

1.INTRODUCTION
11. What Is Risk Management?
1.2Risk Management Systems
1.3Purpose of risk management
1.4 The Risk Analysis Process
2.Empirical analysis
2.1 Correlation
2.2 Capital Asset Pricing Model
2.3 Market Risk VaR

3.Conclusion

3
3
3
3
4
5
5-6
7
7- 12

13

1.INTRODUCTION
This project is about if a CEO is asking for your opinion,what sort of analysis and ideas
you should do. So it is your job to consider how the new venture fits into the companys
portfolio. What is the correlation of the performance of the new venture with the rest
of the companys business? When the rest of the business is experiencing difficulties,
will the new venture also provide poor returns, or will it have the effect of dampening
the ups and downs in the rest of the business?
Companies must take risks if they are to survive and prosper. The risk management functions primary responsibility is to understand the portfolio of risks that
the company is currently taking and the risks it plans to take in the future. It must
decide whether the risks are acceptable and, if they are not acceptable, what action
should be taken.
1.1 What Is Risk Management?
Risk Management is the process of identifying, analyzing and responding to risk factors
throughout the life of a project and in the best interests of its objectives. Proper risk
management implies control of possible future events and is proactive rather than
reactive.
1.2 Risk Management Systems
Risk Management Systems are designed to do more than just identify the risk. The
system must also quantify the risk and predict the impact on the project. The outcome is
therefore a risk that is either acceptable or unacceptable. The acceptance or nonacceptance of a risk is usually dependent on the project manager's tolerance level for
risk.If risk management is set up as a continuous, disciplined process of problem
identification and resolution, then the system will easily supplement other systems. This
includes; organization, planning and budgeting, and cost control. Surprises will be
diminished because emphasis will now be on proactive rather than reactive
management.

1.3The purpose of risk management is to:

Identify possible risks.

Reduce or allocate risks.
Provide a rational basis for better decision making in regards to all risks.
Plan.

Assessing and managing risks is the best weapon you have against project
catastrophes. By evaluating your plan for potential problems and developing strategies

to address them, you'll improve your chances of a successful, if not perfect, project.
Additionally, continuous risk management will:

Ensure that high priority risks are aggressively managed and that all risks are
cost-effectively managed throughout the project.
Provide management at all levels with the information required to make informed
decisions on issues critical to project success.

If you don't actively attack risks, they will actively attack you!!

1.4The Risk Analysis Process

The Risk Analysis Process is essentially a quality problem solving process. Quality and
assessment tools are used to determine and prioritize risks for assessment and
resolution.
The risk analysis process is as follows:
1.Identify the Risk

This step is brainstorming. Reviewing the lists of possible risk sources as well as
the project team's experiences and knowledge, all potential risks are identified.
Using an assessment instrument, risks are then categorized and prioritized. The
number of risks identified usually exceeds the time capacity of the project team to
analyze and develop contingencies. The process of prioritization helps them to
manage those risks that have both a high impact and a high probability of
occurrence.

2. Assess the Risk

Traditional problem solving often moves from problem identification to problem

solution. However, before trying to determine how best to manage risks, the
project team must identify the root causes of the identified risks.
The project team asks questions including:
What would cause this risk?
How will this risk impact the project?

3. Develop Responses to the Risk

Now the project team is ready to begin the process of assessing possible
remedies to manage the risk or possibly, prevent the risk from occurring.
Questions the team will ask include:
What can be done to reduce the likelihood of this risk?

What can be done to manage the risk, should it occur?

4. Develop a Contingency Plan or Preventative Measures for the Risk

The project team will convert into tasks, those ideas that were identified to
reduce or eliminate risk likelihood.
Those tasks identified to manage the risk, should it occur, are developed into
short contingency plans that can be put aside. Should the risk occur, they can be
brought forward and quickly put into action, thereby reducing the need to manage
the risk by crisis.

2.Empirical analysis
In the table below there are given data for security(Y) and market portfolio
(x) of the bank also the interest free which is equal to 2% and market
portfolio equal to 7%. We are going to find correlation ,Capm and Market
risk VAR.
2.1 Correlation
Correlation is a statistical measure that indicates the extent to which two or more
variables fluctuate together. A positive correlation indicates the extent to which those
variables increase or decrease in parallel; a negative correlation indicates the extent to
which one variable increases as the other decreases.
When the fluctuation of one variable reliably predicts a similar fluctuation in another
variable, theres often a tendency to think that means that the change in one causes the
change in the other. However, correlation does not imply causation. There may be, for
example, an unknown factor that influences both variables similarly.
Heres one example: A number of studies report a positive correlation between the
amount of television children watch and the likelihood that they will become bullies.
Media coverage often cites such studies to suggest that watching a lot of television
causes children to become bullies. However, the studies only report a correlation, not
causation. It is likely that some other factor such as a lack of parental supervision
may be the influential factor.
Covariance
Covariance indicates how two variables are related. A positive covariance means the
variables are positively related, while a negative covariance means the variables are
inversely related.

Securtyi(
Y)

Market_portfol
io(X)

35.62175
111
37.08270
218
77.86792
183
92.01979
213
102.7203
548
105.3659
294
107.6204
49
109.4740
304
117.5116
923
133.0332
626
555.033

31.22463556

-3154.529515

26.0263653

-3153.068564

62.35851104

-3112.283344

63.12598925

-3098.131474

71.223796

-3087.430911

70.1529904

-3084.785337

64.99972586

-3082.530817

63.02506639

-3080.677236

63.94658785

-3072.639574

67.99179889

-3057.118003

655.9875

-2635.118266

815.7424
316
206.8557
827
376.1382
043
196.8445
772
121.2193
844
3190.151
266

786.8946557

-2374.408834

192.0270531

-2983.295483

353.4465302

-2814.013062

178.0429465

-2993.306689

107.5003526

-3068.931882

2857.974505

-47852.26899

P (correlation) =

(y1-)

(x x )2
( x1- x )
2826.749869
2831.948139
2795.615994
2794.848515
2786.750709
2787.821514
2792.974779
2794.949438
2794.027917
2789.982706
2201.987005
2071.079849
2665.947452
2504.527974
2679.931558
2750.474152
42869.61757

( y )

9951056.4
61
9941841.3
69
9686307.6
15
9598418.6
3
9532229.6
32
9515900.5
73
9501996.2
38
9490572.2
3
9441113.9
5
9345970.4
87
6943848.2
76
5637817.3
13
8900051.9
41
7918669.5
12
8959884.9
34
9418342.8
94
143784022
.1

covariance( y )( x X )/ varianca xvarianca y

7990514.8
22
8019930.2
64
7815468.7
84
7811178.2
24
7765979.5
12
7771948.7
95
7800708.1
15
7811742.3
62
7806592
7784003.4
98
4848746.7
69
4289371.7
41
7107275.8
14
6272660.3
75
7182033.1
56
7565108.0
61
115643262
.3

x 1 x

Y 1

8917065.
893
8929326.
653
8700749.
094
8658808.
15
8603900.
28
8599830.
928
8609430.
827
8610337.
109
8585040.
747
8529306.
359
5802496.
178
4917590.
29
7953308.
991
7047774.
434
8021857.
059
8441017.
815
12892784
0.8

8057990.05
115643262.3143784022.1

1=

128927840.8
115643262.3

8057990.05
128948258.5

0.062490104

3190.151266 - 1.114875508 *2857.974505 =

3.865487887

B2=

x
x

x
x

( y )

1.114875508

The bigger the correlation is the bigger is the relation between the X and Y . A 3%
increase in the market rate of return leads on the average to about 1.114875508 %
increase in the return on Future fund.

2.2 Capital Asset Pricing Model

Capital asset pricing model (CAPM): a tool to estimate the cost of equity capital using
several empirical inputs: the risk-free rate represents a return an investor can achieve
on the least risky asset in a market; equity beta captures the systematic risk of an
investment; and an equity market risk premium is the premium that a perfectly
diversified equity investor expects to obtain over the risk-free rate. This model predicts
that the expected risk premium for an individual stock will be proportional to its beta.
CAPM is represented by the formula Ri= Rf+ i(Rmf) where: Rirepresents expected rate
of return on asset i; Rfis rate of return on a risk-free asset; Rm represents expected rate
of return on a market portfolio; and i is a beta coefficient of an asset defined as
Cov(Ri,Rm)/(Varm). Various approaches could be used to enhance the application of
CAPM and its beta coefficient, such as altering the period over which to measure beta,
the frequency of observation, comparator analysis with industry sector betas, and
choice of data provider. Comparator analysis, which averages betas across a selection

of comparator/peer companies, can sometimes help estimate betas for organizations

not listed on a stock exchange.
Beta: the factor used in the Capital Asset Pricing Model to reflect the risk associated
with a particular equity. Beta is a proxy for the market risk that shareholders bear.
Changing capital structures can affect expected returns and beta.

CAPM =

ER

Rf

+ 2 * (

EM

Rf

) = 0.02+1.114875508* (0.07

-0.02)
= 0.075743775
If > 1 then we have a aggresive security
If <1 we have a defensive security.
Since =1.114875508 and its >1 then in our company we have an
aggresive security.

2.3 Market Risk VAR

Value at risk (VaR) is an attempt to provide a single number that
summarizes the total risk in a portfolio.

Based on the table of the lecture stock market index in 4 different market
US,UK,FR,JP suppose that the 5 million invested equally in each market.
Estimate the simulation based on the historical data what will happen with
investment in 501,502 day. The 5 th worst scenario is 452000$.

9
Day

Date

DJIA

FTSE

CAC 40

Nikkei

Aug 7, 2006

11,219.38

11,131.84

6,373.89

131.77

Aug 8, 2006

11,173.59

11,096.28

6,378.16

134.38

Aug 9, 2006

11,076.18

11,185.35

6,474.04

135.94

Aug 10, 2006

11,124.37

11,016.71

6,357.49

135.44

..

499

Sep 24, 2008

10,825.17

9,438.58

6,033.93

114.26

500

Sep 25, 2008

11,022.06

9,599.90

6,200.40

112.82

Stock Index

Amount Invested ($000s)

DJIA(Dow Jon Industrial Average) US

5000

FTSE 100 (UK)

5000

CAC 40 (France)

5000

Nikkei 225 (Japan)

Total

5000
20,000

Date 25 september 1st scenario

V501US= V500 X V1/ V0=11022.06 x11173.59/11219.38=10977.08
V5001UK= V500 x V1/ V0=9599.90 X 11096.28/11131.84=9569.23
V5001FR= V500 x V1/ V0=6200.40 X6378.16/6373.89=6204.55
V5001JP= V500 x V1/ V0=112.82 X 134.38/131.77=115.05
Gain=5000 X10977.08/11022.06+5000 X 9569.23/9599.90 + 5000 X
6204.55/6200.40+5000 X 115.05/112.82=19950 $

10

Date 26 September 2nd scenario

V502US= V500 X V1/ V0=11022.06 x 11076.18/11173.59=10925.97
V502Uk= V500 X V1/ V0=9599.90 x 11185.35/11096.28=9676.96
V502FR= V500 X V1/ V0=6200.40 X 6474.04/6378.16=6293.60
V502JP= V500 X V1/ V0=112.82 X135.94/134.38= 114.13
Gain=5000 x 10925.97/11022.06+5000 x 9676.96/9599.90 +5000 x
6293.60/6200.40+5000 x 114.13/112.82=20050
In the first scenario the portofolio has a profit of 50000 $ and the second scenario has a
loss of 50000 $.

Scenario
Number

DJIA

FTSE

CAC

Nikkei

Portfolio
Value

Loss

10,977.08

9,569.23

6,204.55

115.05

19950

-50

10,925.97

9,676.96

6,293.60

114.13

20050

50

VaR=

10 *452=1428.32

-1428.32

1428.32

11

Using the model building approach calculate the value at risk for 4 securities with
a volatility 5%,6%,7%,8%. Find the VaR separately for each of them and together
as a portofolio. Coefficient of correlation is 0.8 and 99 % confidence level.
Investment 1=20 M
Volatility yearly=

volatility 5%

256 x 0.05=80% yearly

SDEV=5% X 20000=1000 $
=1000 X 10 =3160
VaR=2.33 X 3160=7362.8

-7362.8

7362.8

Investment 2=20000
Volatility yearly=

volatility=6%

256 x0.06=96%

SDEV=6% X 20000=1200 $

=1200 X

20M=20000

10

=3792

VaR=2.33 X3792=8835.36

12

-8835.36

8835.36

Investment 3=20000
Volatility yearly=

volatility=7%

256 x0.07=112%

SDEV=7% X 20000=1400 $
=1400 X

10

=4424

VaR=2.33 X 4424=10307.92

-10307.92 0

+10307.92

Investment 4=20000
Volatility yearly=

volatility=8%

256 x0.08=128%

SDEV=8% x 20000=1600 $
=1600 X 10

=5056

VaR=2.33 x 5056=11780.48

13

-11780.48

11780.48

VaR for portofolio

1=2=3=4=20 ' 000

p=1

x 1

2x

+ 2

1=5 2=6 3=7 4=8

2

x 2

+ 3

x 3

+ 4

p=0.8 20000=20
2

+4p

1 2 3 4 1 2 3 4 =20x0.0025+20x0.0036+20x0.0049+20x0.0064+4x0.8x20x20x

20x20x0.05x0.06x0.07x0.08=1+1.44+1.96+2.56+8.6016= 155616
VaR=155616 x 2.33 x

-114570

10 =114570 $

114570

3.Conclusion
In this project we learned what is the correlation of the performance of the new venture
with the rest of the companys business? When the rest of the business is experiencing
difficulties,will the new product also provide poor returns, or will it have the effect of
dampening the ups and downs in the rest of the business?
We did a lot of empirical analysis like correlation , CAPM, and VAR.
Correlation is a statistical measure that indicates the extent to which two or more
variables fluctuate together. A positive correlation indicates the extent to which those
variables increase or decrease in parallel; a negative correlation indicates the extent to

14

which one variable increases as the other decreases.And by our datas we know that
The bigger the correlation is the bigger is the relation between the X and Y . A 3%
increase in the market rate of return leads on the average to about 1.114875508 %
increase in the return on Future fund.
Capital asset pricing model (CAPM): a tool to estimate the cost of equity capital
usingseveral empirical inputs: the risk-free rate represents a return an investor can
achieve on the least risky asset in a market; equity beta captures the systematic risk of
an investment; and an equity market risk premium is the premium that a perfectly
diversified equity investor expects to obtain over the risk-free rate. Since
=1.114875508 and its >1 then in our company we have an aggresive security.
And Value at risk (VaR) is an attempt to provide a single number that summarizes the
total risk in a portfolio. In the first scenario the portofolio has a profit of 50000 $ and the
second scenario has a loss of 50000 $. And by each investement showed in the datas
above in the exercise we have a portfolio VAR equal to 114570 $ and we have a profit
not higher then 114570 $ and the higher loss 114570 $ .
Now we can identify, analyze and responde to risk factors throughout the life of a project
and in the best interests of objectives of the bank.

THANK YOU !!!