Module 2: Measuring Risk

Dr. Sankersan Sarkar

Why Measure Risk?

Risk Risk Aversion Risk Premium Required Return There are several approaches to measure risk specific to the type of risk & its context

Contents
Using probabilities to measure risk Insurance view of risk Financial assets & use of statistical measures Markowitz portfolio theory Capital Asset Pricing Model (CAPM) Limitations of Mean-Variance framework & other limitations Arbitrage Pricing Theory & Multifactor models

Using probabilities to measure risk

Use of normal distribution to measure risk Use of actuarial tables

Using probabilities to measure risk

Use of normal distribution & related approaches
1. Law of large numbers - Jacob Bernoulli A randomly drawn large sample of items from a population has the same characteristics as the population itself evolution of sampling theory for generalising population characteristics on the basis of sample characteristics 2. Normal Distribution- De Moivre, Laplace & Gauss Can be defined by just two parameters e.g. mean & S.D, and can be used for drawing inferences on population means Can be used as an approximation for other distributions Central Limit Theorem 3. Conditional Probabilities & Bayes theorem Revision of prior probabilities with new information

Using probabilities to measure risk

Use of Actuarial tables Actuarial tables Mortality/Life tables, Morbidity tables & other types These tables help to draw important inferences e.g. the probability a person will survive any particular year of age, remaining life expectancy at various ages etc. Mortality rates of men & women natural / based on other attributes smoking/drinking/occupational hazards etc Based on the availability of data similar tables can be prepared & maintained for events like: hurricanes, fires, accidents, heart attacks & other risk factors

Some Contexts of Measuring Risk

Insurance Financial investments

Insurance view of Risk

Insurance is offered when the time of occurrence of a loss is unpredictable but the likelihood and magnitude of the loss are measurable Insurance companies measure the probabilities of specific risks and the extent of resulting losses Based on this they calculate expected losses for specific risks For each client they charge a premium higher than the expected loss from specific risks, which covers their losses & costs, and provides them profit margin

Insurance view of Risk

By insuring a specific risk for many clients they ensure that their profits exceed the expected losses over time Major concern: Natural calamities they cause massive losses which may make the insurance co. bankrupt This has led to the practice of Reinsurance So insurance cos. look at risks from the perspective of losses downside impact of risk risk is a loss function in insurance

Financial assets and use of statistical measures

Investors in financial assets are exposed to both upside and downside impacts of risk So risk can also be seen as a source of profit instead of just as a loss function Various measures of risk have been used based on past prices, accounting information, broad risk categories etc However the best method to measure risk is still debatable

Financial assets and use of statistical measures

Statistical measures of risk evolved in the financial context because of the two-sided impact of risk S.D / Variance of returns is commonly used This is particularly chosen because S.D can be used for drawing statistics based inferences on the return data (with the assumption of normal distribution)

Financial assets and use of statistical measures

Theories that evolved in this context focus on two issues: a. Portfolio construction: MPT (Markowitz) b. Asset pricing CAPM APT Multi-factor & proxy models

Markowitz Portfolio Theory

The concept of Diversification was well in place before Markowitz proposed his theory Markowitz made two major contributions: a) Correlation among the securities an important determinant of portfolio risk b) Process to generate optimally diversified portfolios efficient portfolios & efficient frontier

Markowitz efficient frontier

Markowitz Portfolio Theory This theory rests on 2 assumptions Investors utility functions are based on only expected returns & variance of returns Returns are normally distributed

Markowitz Portfolio Theory - Limitations

The 1st assumption implies that investors utility is a quadratic function of their wealth Investors with quadratic utility function focus only on the level of their wealth & variance around that level So they would select investments on the basis mean & variance of returns A quadratic utility function creates the mean variance framework for decision making hence convenient but not reasonable WHY???

Markowitz Portfolio Theory

Investors Utility as Quadratic function of Wealth U(W)= a+bW-cW2

Markowitz Portfolio Theory - Limitations

Limitation: Assumptions are not realistic for 3 reasons: 1. It implies that investors are equally averse to deviations of wealth from mean, both above (favourable) & below (adverse) it 2. It shows an increasing absolute risk aversion 3. For specific ranges it shows that investors would prefer less wealth over more wealth marginal utility of wealth is -ve

Markowitz Portfolio Theory - Limitations The 2nd assumption (Normality) implies that investors choice of a portfolio depends only on two variables mean & variance of returns This is another necessary condition for the mean-variance framework Limitation: Normal distribution can not be the appropriate distribution for investment returns

Implications of MPT for Risk Assessment

The argument for diversification (portfolio of assets) becomes very strong notwithstanding privileged information / transaction costs The relevant measure of asset risk is the risk that it adds on to the portfolio to which it is included, and not its variability per se This means the relevant measure of risk of an asset is by how much it increases the variance of the portfolio to which it is added

Implications of MPT for Risk Assessment

The riskiness of an asset can be measured not in isolation but with reference to the portfolio to which it will be added Hence risk of a specific asset should be the comovement of its market value with the market values of the other assets in the portfolio Mathematically: Risk of an asset should be measured in terms of the covariance of its returns with the returns from other assets in the portfolio not just the variance of returns of the asset concerned

Further Implications for Risk Assessment

Correct assessment of risk is essential in order to know the optimal risk-return combination of a portfolio If the risk-return combination of a portfolio is not optimal then it indicates that it is not properly diversified

Capital Asset Pricing Model

Origin Built upon the Mean-Variance framework (MPT) developed by Markowitz; it extended the MPT in two major ways: a. Minimising the data required for identifying the efficient portfolios in the original model b. Creating more efficient portfolios by introducing a risk-free asset in the MeanVariance framework Evolved as an asset pricing theory

CAPM
Explains the behaviour of the Efficient Frontier in the MPT when a riskless asset is introduced Riskless asset represents the opportunity to lend/borrow at the risk-free rate Proved that all investors depending on their risk appetite will combine the risk-free asset with only one specific efficient portfolio in the Efficient Frontier

CAPM
This particular efficient portfolio was called the market portfolio Investors with more/less risk appetite will make different combinations of the risk-free asset & the market portfolio thus changing the shape of the Efficient Frontier Unlevered (lending) portfolios & Levered (borrowing) portfolios Shape of the efficient frontier changes from a curve to a straight line

CAPM explained through Lending and Borrowing opportunities

Assumptions of CAPM
No transaction costs, no taxes, investors have identical information, borrowing & lending at risk free rate etc. in addition to MPT assumptions These assumptions are there to eliminate the possibility of not holding a fully diversified portfolio So the risk of an individual asset is the risk added on to the market portfolio by the asset This risk is measured by the covariance of the asset with the market portfolio

CAPM and concept of Beta

However this covariance is an absolute measure of risk and is not comparable across assets. Therefore, dividing the covariance between the asset & market returns by the variance of market returns would give a comparable risk measurement (that can be used as a standard)
Covariance of Asset with Market portfolio

Risk of an asset=

Variance of the Market portfolio

Asset Beta ()

Limitations of mean-variance framework

(A) Fat-Tails and Power Law Distributions Stock prices and investment returns exhibit too large values which are not likely to be drawn from a normal distribution their distributions have fatter tails than the normal distribution These fat-tails can not be explained by mean variance framework (normal distribution) Power law distribution Y= Xk better explains the fat tails, where Y and X are variables, =constant, k= power law exponent Power law distributions better fit into a data series that behaves violently with wild randomness

Limitations of mean-variance framework

(B) Asymmetric distributions
In volatile market conditions the downside impact of risk matters more than the upside impact Studies confirm that human beings are more worried for downside risk than the upside risk and they tend to show (a) loss aversion (b) serious consideration for large positive payoffs without concerning the probability of such returns These results can be better explained by Asymmetric / Skewed (+vely) Distributions with fat tails A better measure of return should also consider the possibility of very large returns with the expected return A better measure risk should include the possibility of large movements with the variance of returns

Asymmetric Distributions

Limitations of mean-variance framework

(C ) Jump Process Models Stock prices and Returns tend to jump at some intervals of time and are not continuous all the time Hence they can not be explained by continuous distribution models e.g. normal distribution and asymmetric distributions So Jump process models which combine both the continuous and discrete distributions are better models to explain the stock price behavior

Arbitrage Pricing Theory

Based on two observations: Two assets having the same exposure to risk can not be priced differently at the same time otherwise there will be an arbitrage opportunity Large numbers of stocks tend to move together in particular periods of time

There are multiple market factors that affect many stocks at the same time

Arbitrage Pricing theory vs CAPM

APT replaced a single market risk factor proposed by CAPM by multiple market risk factors The relationship of these factors with the returns from the asset is given by factor betas APT did not make any restrictive assumptions about the investor utility functions or the return distribution of assets.
However the APT depends heavily on the amounts of historical data on asset prices for the estimation of both the number of factors and the factor betas

Multi-factor & Proxy Models

These models are based on multiple economic variables Multi-factor models use macroeconomic variables e.g. level of industrial production, changes in default risk spread between corporate & treasury bonds, shifts in yield curve, variations in real rate of interest, unanticipated inflation etc. Proxy models include firm-specific factors e.g. Market capitalization and book-to-price ratio

Multi-factor & Proxy Models

The exposure of asset returns to each of these factors is called factor beta & the betas for various factors can be estimated by statistical techniques These models assume that: a. Stock prices change for appropriate reasons b. Stocks that earn higher returns over long periods must be riskier than those that earn lower returns during the same periods

Thank you