FUNDAMENTALS OF

FINANCIAL RISK
PROF. G. VENKATAKRISHNAN
Risk Management Process - Overview
• Risk management encompasses the identification, analysis, and
response to risk factors that form part of the life of a business.
• Effective risk management means attempting to control, as much as
possible, future outcomes by acting proactively rather than reactively.
• Therefore, effective risk management offers the potential to reduce
both the possibility of a risk occurring and its potential impact.
The Risk Management Process

1. Establishing the context

2. Risk identification
3. Risk analysis
4. Risk evaluation
5. Risk treatment
6. Communication & consultation
7. Monitoring and review
Steps in Risk Management Process
• Establish the context : In order to understand and manage risk, it’s first
necessary to understand your entity’s objectives and operating environment.
• Establishing the context is the first of the seven risk management steps where
the objectives and influences of the risk management process are defined.
• Risk identification: The aim of this step is to develop a comprehensive and
tailored list of future events which could be uncertain, but are likely to have an
impact (either positively or negatively) on the achievement of the objectives -
these are the risks.
• Risks need to be documented including key elements such as the risk event,
the potential cause and the potential impact should the risk be realised.
 Risk analysis
• Risk analysis establishes the potential impact of each risk and its likelihood of
occurrence.
• The combination of these two factors determines the severity of the risk,
which may be positive or negative.
• Although there are many ways to achieve this, a common approach is to use a
matrix or ‘risk heat map’.
• Whilst entities may use different processes for analysing risk, it is important
that each entity ensures all risks within its organisation are assessed
consistently.
• Good communication is required to ensure each stakeholder understands the
severity of the risks.
 Risk evaluation
• Risk evaluation determines the tolerability of each risk.
• Tolerability is different from severity. Tolerability assists to determine
which risks need treatment and the relative priority.
• At its simplest, an entity might decide that risks above a certain severity
are unacceptable, and risks below this are tolerable.
• Decisions on tolerability should also be made after considering the
broader context of the risk including the impact of the risk upon other
entities outside of the organisation.
• Treatment decisions should consider financial, legal, regulatory and
other requirements
 Risk treatment

• Risk treatment is the action taken in response to the risk evaluation, where it
has been agreed that additional mitigation activities are required.
Risk treatment can include strategies such as:
Avoiding the risk entirely by not undertaking the activity
Removing a source or cause of the risk
 Sharing the risk with other parties
Retaining the risk by informed decision
Taking more risk to achieve certain objectives or opportunities
Changing the likelihood and/or consequence of the risk through modifying
controls in place.
 Communication and consultation
• Communication and consultation is an essential attribute of good risk
management.
• Risk management is fundamentally communicative and consultative.
• Good risk communication generally includes the following attributes:
encourages stakeholder engagement and accountability
maximises the information obtained to reduce uncertainty
meets the reporting and assurance needs of stakeholders
 ensures that relevant expertise is drawn upon to inform each step of the process
informs other entity processes such as corporate planning and resource
allocation.
 Monitoring and review
• Monitoring and review is integral to successful risk management
• Key objectives of risk monitoring and review include:
 detecting changes in the internal and external environment, including evolving
entity objectives and strategies
identifying new or emerging risks
 ensuring the continued effectiveness and relevance of controls and the
implementation of treatment programs
 obtaining further information to improve the understanding and management of
already identified risks
 analysing and learning lessons from events, including near-misses, successes and
failures
 Risk Management Structures

• Risk management structures are tailored to do more than just point out existing risks.
• A good risk management structure should also calculate the uncertainties and predict their
influence on a business.
• Consequently, the result is a choice between accepting risks or rejecting them.
• Acceptance or rejection of risks is dependent on the tolerance levels that a business has
already defined for itself.
• If a business sets up risk management as a disciplined and continuous process for the
purpose of identifying and resolving risks, then the risk management structures can be
used to support other risk mitigation systems.
• They include planning, organization, cost control, and budgeting.
 Response to Risks
Response to risks usually takes one of the following forms:
•Avoidance: A business strives to eliminate a particular risk by getting rid of its cause.
•Mitigation: Decreasing the projected financial value associated with a risk by lowering the
possibility of the occurrence of the risk.
•Acceptance: In some cases, a business may be forced to accept a risk. This option is
possible if a business entity develops contingencies to mitigate the impact of the risk,
should it occur.
•Transferring risk: Contractually transferring a risk to a third-party, such as, insurance to
cover possible property damage or injury shifts the risks associated with the property from
the owner to the insurance company.
•Risk acceptance and retention: After all risk sharing, risk transfer and risk reduction
measures have been implemented, some risk will remain since it is virtually impossible to
eliminate all risk (except through risk avoidance). This is called residual risk.
 Importance of Risk Management
• Risk management is an important process because it empowers a business with
the necessary tools so that it can adequately identify and deal with potential risks.
• Once a risk has been identified, it is then easy to mitigate it. In addition, risk
management provides a business with a basis upon which it can undertake sound
decision-making.
• For a business, assessment and management of risks is the best way to prepare for
eventualities that may come in the way of progress and growth.
• In addition, progressive risk management ensures risks of a high priority are dealt
with as aggressively as possible.
• Moreover, the management will have the necessary information that they can use
to make informed decisions and ensure that the business remains profitable.
 Risk Analysis Process

• 1. Identify existing risks

• 2. Assess the risks
• 3. Develop an appropriate response
• 4. Develop preventive mechanisms for identified risks
 Basics of Financial Risk
What is Financial Risk?
• Financial risk is the possibility of losing money on an investment or
business venture.
• Financial risk is a type of danger that can result in the loss of capital to
interested parties.
• Many analysis identify at least five types of financial risk: market risk,
credit risk, liquidity risk, operational risk, and legal risk.
 What is Financial Risk?
• Financial risk is a type of danger that can result in the loss of capital to
interested parties.
• For governments, this can mean they are unable to control monetary
policy and default on bonds or other debt issues.
• Companies also face the possibility of default on debt they undertake
but may also experience failure in an undertaking the causes a
financial burden on the business.
• Financial risk generally relates to the odds of losing money.
• The financial risk most commonly referred to is the possibility that a
company's cash flow will prove inadequate to meet its obligations.
• Credit risk, liquidity risk, asset-backed risk, foreign investment risk,
equity risk, and currency risk are all common forms of financial risk
• Investors can use a number of financial risk ratios to assess a
company's prospects.
• Financial markets face financial risk due to various macroeconomic
forces, changes to the market interest rate, and the possibility of
default by sectors or large companies.
• Individuals face financial risk when they make decisions that may
jeopardize their income or ability to pay a debt they have assumed.
• Financial risks are everywhere and come in many shapes and sizes,
affecting nearly everyone.
• Knowing the dangers and how to protect yourself will not eliminate
the risk, but it can mitigate their harm and reduce the chances of a
negative outcome.
• The need for funding creates a financial risk to both the business and
to any investors or stakeholders invested in the company.
Types of Financial Risks
 Credit Risk
• Also known as default risk—is the danger associated with lending money.
• if the borrower become unable to repay the loan, they will default. Investors affected by credit
risk suffer from decreased income from loan repayments, as well as lost principal and interest.
• Credit risk is the probability of a financial loss resulting from a borrower's failure to repay a
loan.
• Essentially, credit risk refers to the risk that a lender may not receive the owed principal and
interest, which results in an interruption of cash flows and increased costs for collection.
• Lenders can mitigate credit risk by analyzing factors about a borrower's creditworthiness, such
as their current debt load and income.
• Consumer credit risk can be measured by the five Cs: credit history, capacity to repay, capital,
the loan's conditions, and associated collateral.
• Consumers who are higher credit risks are charged higher interest rates on loans.
• The higher the credit risk , the higher will be the interest rate charged to the borrower.
Operational risk-
Businesses can experience operational risk when they have poor
management or flawed financial reasoning. Based on internal factors, this
is the risk of failing to succeed in its undertakings.
Systematic Risk-
Systemic risk affects (almost) every company and industry.
the wise investor minimizes by diversifying.
Asset-backed risk refers to the potential for loss or volatility associated
with investments backed by specific assets, such as loans or mortgages,
due to factors like default, market fluctuations, or changes in the value of
the underlying assets.
 Specific Risk
• To an investor, specific risk is a hazard that applies only to a particular
company, industry, or sector. It is the opposite of overall market risk or
systematic risk.
• Specific risk is also referred to as unsystematic risk or diversifiable risk.
• Specific risk is peculiar to a company or an industry.
• This danger, related to a company or small group of companies, includes issues
related to capital structure, financial transactions, and exposure to default.
• The term is typically used to reflect an investor's uncertainty about collecting
returns and the accompanying potential for monetary loss.
• The wise investor minimizes both by diversifying.
 The Impact of Financial Risks on Markets

• Several types of financial risk are tied to financial markets.

• As demonstrated during the 2007 to 2008 global financial crisis, when a
critical sector of the market struggles it can impact the monetary
wellbeing of the entire marketplace.
• Volatility brings uncertainty about the fair value of market assets.
• Volatility or equity risk can cause abrupt price swings in shares of stock.
• Default and changes in the market interest rate can also pose a financial
risk.
• Defaults happen mainly in the debt or bond market as companies or other
issuers fail to pay their debt obligations, harming investors.
 How Financial Risks Impact Individuals

• Individuals can face financial risk when they make poor decisions.
• Every undertaking has exposure to pure risk—dangers that cannot be
controlled, but some are done without fully realizing the consequences.
• Liquidity risk comes in two flavors for investors to fear.
The first involves securities and assets that cannot be purchased or sold
quickly enough to cut losses in a volatile market. Eg- gold, real estate
The second risk is funding or cash flow liquidity risk. Funding liquidity risk
is the possibility that a company will not have the capital to pay its debt,
forcing it to default, and harming stakeholders.
 How Financial Risks Impact
Individuals
• Speculative risk is one where a profit or gain has an uncertain
chance of success. Perhaps the investor did not conduct proper
research before investing, reached too far for gains, or invested too
large of a portion of their net worth into a single investment.

• Investors holding foreign currencies are exposed to currency risk

because different factors, such as interest rate changes and
monetary policy changes
 Pros and Cons of Financial Risk
• Pros:
• Encourages more informed decisions
• Helps assess value (risk-reward ratio)
• Can be identified using analysis tools

• Cons:
• Can arise from uncontrollable or unpredictable outside forces
• Risks can be difficult to overcome
• Ability to spread and affect entire sectors or markets
 Tools to Control Financial Risk

• Fundamental analysis, the process of measuring a security's

intrinsic value by evaluating all aspects of the underlying business
including the firm's assets and its earnings.
• Technical analysis, the process of evaluating securities through
statistics and looking at historical returns, trade volume, share
prices, and other performance data.
• Quantitative analysis, the evaluation of the historical performance
of a company using specific financial ratio calculations.
Introduction to Statistical Tools for Risk
Management
• Risk management involves identifying and analyzing risk in an investment
and deciding whether or not to accept that risk given the expected returns for
the investment.
• Some common measurements of risk include standard deviation, Sharpe
ratio, beta, value at risk (VaR), conditional value at risk (CVaR), and R-
squared.
• Value at Risk and other variations not only quantify a potential dollar impact
but assess a confidence interval of the likelihood of an outcome.
• Risk management also oversees systematic risk and unsystematic risk, the
two broad types of risk impacting all investments.
• A brief introduction to the above is given in the following slides.
 Standard Deviation

• Standard deviation measures the dispersion of data from its

expected value.
• The standard deviation is commonly used to measure the
historical volatility associated with an investment relative to its
annual rate of return.
• It indicates how much of the current return is deviating from its
expected historical normal returns.
• For example, a stock that has high standard deviation experiences
higher volatility and is therefore considered riskier.
 Sharpe Ratio

• The Sharpe ratio measures investment performance by considering associated risks

• To calculate the Sharpe ratio, the risk-free rate of return is removed from the overall
expected return of an investment.
• The remaining return is then divided by the associated investment’s standard
deviation.
• The result is a ratio that compares the return specific to an investment with the
associated level of volatility an investor is required to assume for holding the
investment.
• The Sharpe ratio serves as an indicator of whether an investment's return is worth the
associated risk.
• The Sharpe ratio is most useful when evaluating differing options
 Beta

• Beta measures the amount of systematic risk an individual security or sector

has relative to the entire stock market.
• The market is always the beta benchmark an investment is compared to, and
the market always has a beta of one.
• If a security's beta is equal to one, the security has exactly the same volatility
profile as the broad market.
• A security with a beta greater than one means it is more volatile than the
market
• A security with a beta less than one means it is less volatile than the market.
• Beta is most useful when comparing an investment against the broad market.
 Value at Risk (VaR)

• Value at Risk (VaR) is a statistical measurement used to assess the level of risk associated with a
portfolio or company.
• The VaR measures the maximum potential loss with a degree of confidence for a specified period.
• For example, suppose a portfolio of investments has a one-year 10% VaR of $5 million. Therefore,
the portfolio has a 10% chance of losing $5 million over a one-year period.
• There are several different methods for calculating Value at Risk, each of which with its own
formula:
• The historical simulation method is the simplest as it takes prior market data over a defined
period and applies those outcomes to the current state of an investment.
• The parametric method or variance-covariance method is more useful when dealing with larger
data sets.
• The Monte Carlo method is best suited for the most complicated simulations and assumes the
probability of risk for each risk factor is known.
 R-squared

• R-squared is a statistical measure that represents the percentage of

a fund portfolio or a security's movements that can be explained by
movements in a benchmark index.
• For fixed-income securities and bond funds, the benchmark is the
U.S. Treasury Bill. The S&P 500 Index is the benchmark for equities
and equity funds.
• R-squared values range from zero to one and are commonly stated
as a percentage (0% to 100%) An R-squared value of 0.9 means 90%
of the analysis accounts for 90% of the variation within the data.
 Categories of Risks

• Risk management is divided into two broad categories: systematic and

unsystematic risk.
• Every investment is impacted by both types of risk, though the risk
composition will vary across securities.
• Systematic risk is associated with the overall market. This risk affects
every security, and it is unpredictable and undiversifiable. However,
systematic risk can be mitigated through hedging.
• Unsystematic risk, is specifically associated with a company or sector.
It is also known as diversifiable risk and can be mitigated through asset
diversification. This risk is only inherent to a specific stock or industry.
 Quantification of Risk
• Investors can use models to help differentiate between risky investments
and stable ones.
• Modern portfolio theory is used to understand the risk of a portfolio
relative to its return.
• Diversification can reduce risk and optimal diversification is
accomplished by building a portfolio of uncorrelated assets.
• Beta, standard deviations, and VaR measure risk, but in different ways.
• Each has its own merits and demerits.
 Alpha and Beta Ratios
• Beta, standard deviations, and VaR measure risk, but in different ways.
• Both are risk ratios used in Modern Portfolio Theory and help to determine
the risk/reward profile of investment securities.
• Alpha measures the performance of an investment portfolio and compares it
to a benchmark index, such as the S&P 500.
• The difference between the returns of a portfolio and the benchmark is
referred to as alpha
• A positive alpha of one means the portfolio has outperformed the
benchmark by 1%
• Likewise, a negative alpha indicates the underperformance of an investment.
• Beta measures the volatility of a portfolio compared to a benchmark index
• The statistical measure beta is used in the CAPM, (Capital Asset Pricing Model) which
uses risk and return to price an asset.
• Unlike alpha, beta captures the movements and swings in asset prices.
• A beta greater than one indicates higher volatility, whereas a beta under one means
the security will be more stable
• For example, Amazon (AMZN), with a beta coefficient (5Y monthly average) of
1.15 represents a less risky investment than Carnival Corp (CCL), which has a
beta of 2.32
 Risk vs Return - Risk Adjusted Return
• Risk-adjusted return defines an investment's return by measuring how
much risk is involved in producing that return, which is generally
expressed as a number or rating. Risk-adjusted returns are applied to
individual securities, investment funds and portfolios.
• Risk-adjusted return on capital is a risk-based profitability
measurement framework for analysing risk-adjusted financial
performance and providing a consistent view of profitability across
businesses.
• The concept was developed by Bankers Trust and principal designer
Dan Borge in the late 1970s.
 Risk vs Return - Risk Adjusted Return
• Risk-adjusted return defines an investment's return by measuring how
much risk is involved in producing that return, which is generally
expressed as a number or rating. Risk-adjusted returns are applied to
individual securities, investment funds and portfolios.
• Risk-adjusted return on capital is a risk-based profitability
measurement framework for analysing risk-adjusted financial
performance and providing a consistent view of profitability across
businesses.
• The concept was developed by Bankers Trust and principal designer
Dan Borge in the late 1970s.
Why are Risk Adjusted Returns crucial ?
Commonly used Risk Adjusted Return Ratios
• Sharpe Ratio
• Treynor Ratio
• Jensen’s Alpha
• R Squared
• Sortino’s Ratio
• Beta
• Standard Deviation
 Sharpe Ratio
• The Sharpe ratio symbolizes how well the return of an asset compensates the
investor for the risk taken
• When comparing two assets against a common benchmark, the one with a
higher Sharpe ratio provides better return for the same risk (or, equivalently,
the same return for lower risk).
• Developed by Nobel Prize winner, William F. Sharpe in 1966
• Sharpe ratio is defined as the average return earned in excess of the
risk-free rate per unit of volatility or total risk i.e standard deviation.
• The Sharpe ratio has become the most widely used method for calculating
risk-adjusted return, however, it can only be accurate if the data has a normal
distribution.
 Formula for Sharpe Ratio

•Rp = Expected Portfolio Return

•Rf – Risk Free Rate
•Sigma(p) = Portfolio Standard Deviation

The Sharpe ratio can also help determine whether a security’s excess returns are a result of prudent
investment decisions or just too much risk. Even as one fund or security can reap higher returns than its
counterparts, the investment can be considered good if those higher returns are free from an element
of additional risk. The more the Sharpe ratio, the better is its risk adjusted performance.
 Example of Sharpe Ratio
• Let’s assume that the 10-year annual return for the S&P 500 (market
portfolio) is 10%, while the average annual return on Treasury bills (a
good proxy for the risk-free rate) is 5%. The standard deviation is 15%
over a 10-year period.
Average Annual Portfolio Standard
Managers Rank
Return Deviation

Fund A 10% 0.95 III

Fund B 12% 0.30 I
Fund C 8% 0.28 II
Market = (.10-.05)/0.15 =0.33
(Fund A) = (0.10-.05)/0.95= 0.052
(Fund B) = (0.12-.05)/0.30 = 0.233
(Fund C) = (.08-.05)/0.28 = .0.107
 Treynor Ratio
• The increase in return with every unit increase of beta.
• Treynor is a measurement of the returns earned in excess of that
which could have been earned on an investment that has no
diversifiable risk. In short, it is also a reward-volatility ratio, just like
the Sharpe’s ratio, but with just one difference. It
uses a beta coefficient in place of standard deviations.

Rp = Expected Portfolio Return

Rf – Risk Free Rate
Beta(p) = Portfolio Beta
The Treynor ratio depends upon beta – which depicts the sensitivity of an investment to
movements in the market – to evaluate the risk
 Example of Treynor Ratio
• Let’s assume that the 10-year annual return for the S&P 500 (market
portfolio) is 10%, while the average annual return on Treasury bills (a
good proxy for the risk-free rate) is 5%.

Managers Average Annual Return Beta Rank

Fund A 12% 0.95 II
Fund B 15% 1.05 I
Fund C 10% 1.10 III

Market = (.10-.05)/1 = .05

(Fund A) = (.12-.05)/0.95 = .073
(Fund B) = (.15-.05)/1.05 = .095
(Fund C) = (.10-.05)/1.10 = .045
 Treynor Ratio
• Treynor is a measurement of the returns earned in excess of that
which could have been earned on an investment that has no
diversifiable risk. In short, it is also a reward-volatility ratio, just like
the Sharpe’s ratio, but with just one difference. It
uses a beta coefficient in place of standard deviations.

Rp = Expected Portfolio Return

Rf – Risk Free Rate
Beta(p) = Portfolio Beta
The Treynor ratio depends upon beta – which depicts the sensitivity of an investment to
movements in the market – to evaluate the risk
 Jensen’s Alpha
• Alpha is often considered the active return on an investment. It
determines the performance of an investment against a market
index used as a benchmark, as they are often considered to
represent the market’s movement as a whole. The excess returns of
a fund as compared to the return of a benchmark index is the
fund’s alpha
Jensen’s Alpha = Rp - [Rf + Bp (Rm-Rf)]
Rp = Expected Portfolio Return
Rf – Risk Free Rate
Beta(p) = Portfolio Beta
Rm = Market Return

Alpha<0: the investment has earned too little for its risk (or, was too risky for the return)
Alpha=0: the investment has earned a return adequate for the risk taken
Alpha>0: the investment has a return in excess of the reward for the assumed risk
 Example of Jensen’s Alpha
• Let us assume a portfolio realized a return of 17% in the previous year. The
approximate market index for this fund returned 12.5%. The beta of the fund
versus the same index is 1.4 and the risk-free rate is 4%.
• Thus, Jensen’s Alpha = 17 – [4 + 1.4 *(12.5-4)]
• = 17 – [4 + 1.4* 8.5] = = 17 – [4 + 11.9] = 1.1%
• Given, the Beta of 1.4, the fund is expected to be risky than the market index
and thus earn more. A positive alpha is an indication that the portfolio
manager earned substantial return to be compensated for the additional risk
taken over the course over the year. If the fund would have returned 15%, the
computed alpha would be -0.9%. A negative alpha indicates that the investor
was not earning enough returns for the quantum of risk which was borne.
 R Squared
• R-squared is a statistical measure that represents the percentage of a fund or
security’s movements that is based on the movements in a benchmark index.
• R-squared values range from 0 to 1 and are commonly stated as percentages
from 0 to 100%.
• An R-squared of 100% means all movements of a security can be completely
justified by movements in the index.
• A high R-squared, between 85% and 100%, indicates the fund’s performance
patterns reflect that of the index.
• However, strong outperformance coupled with a very low R-Squared ratio will
mean more analysis is required to identify the reason of outperformance.
 Sortino’s Ratio
• Sortino ratio is a variation of the Sharpe ratio. Sortino takes the
portfolio’s return and divides this by the portfolio’s “Downside risk”
Downside risk is the volatility of returns below a specified level,
usually the portfolio’s average return or returns below zero. Sortino
shows the ratio of return generated “per unit of downside risk”.
• Standard deviation includes both the upward as well as the downwar
d volatility
. However, most investors are primarily concerned about the
downward volatility. Therefore, Sortino ratio depicts a more realistic
measure of the downside risk embedded in the fund or the stock.
Rp = Expected Portfolio Return
Rf – Risk-Free Rate
 Example of Sortino’s Ratio
• Let’s assume Mutual Fund A has an annualized return of 15% and a
downside deviation of 8%. Mutual Fund B has an annualized return of
12% and a downside deviation of 5%. The risk-free rate is 2.5%.
• The Sortino ratios for both funds would be calculated as:
• Mutual Fund X Sortino = (15% – 2.5%) / 8% = 1.56
• Mutual Fund Z Sortino = (12% – 2.5%) / 5% = 1.18
 BETA
• In finance, the beta (β or beta coefficient) of an investment is a measure of the risk arising from
exposure to general market movements as opposed to idiosyncratic factors.
• The market portfolio of all investable assets has a beta of exactly 1. A beta below 1 can indicate
either an investment with lower volatility than the market, or a volatile investment whose price
movements are not highly correlated with the market.[1] An example of the first is a treasury bill: the
price does not go up or down a lot, so it has a low beta. An example of the second is gold. The price
of gold does go up and down a lot, but not in the same direction or at the same time as the market.
[2]

• A beta greater than 1 generally means that the asset both is volatile and tends to move up and down
with the market. An example is a stock in a big technology company. Negative betas are possible for
investments that tend to go down when the market goes up, and vice versa. There are few
fundamental investments with consistent and significant negative betas, but some derivatives like
put options can have large negative betas.[3]
• A stock that swings more than the market over time has a beta greater than 1.0. If a stock
moves less than the market, the stock's beta is less than 1.0
 How to Calculate Beta
Beta= Variance divided by Covariance
Covariance= Measure of a stock’s return relative to that of the market
Variance=Measure of how the market moves relative to its mean​
• Covariance measures how two stocks move together. A positive covariance
means the stocks tend to move together when their prices go up or down. A
negative covariance means the stocks move opposite of each other.
• Variance, on the other hand, refers to how far a stock moves relative to its
mean. For example, variance is used in measuring the volatility of an
individual stock's price over time. Covariance is used to measure the
correlation in price moves of two different stocks.
 Example of Beta Calculation
• Calculating the Beta for Apple Inc. (AAPL): An investor is looking to
calculate the beta of Apple Inc. (AAPL) as compared to the SPDR S&P 500
ETF Trust (SPY). Based on data over the past five years, the correlation
between AAPL, and SPY is 0.83. AAPL has a standard deviation of returns
of 23.42% and SPY has a standard deviation of returns of 32.21%.
• Beta of AAPL=0.83×(0.2342/0.3221​)=0.6035​
In this case, Apple is considered less volatile than the market
exchange-traded fund (ETF) as its beta of 0.6035 indicates that the stock
theoretically experiences 40% less volatility than the SPDR S&P 500
Exchange Traded Fund Trust.
 Standard Deviation
• SD is a quantity expressing by how much the members of a group differ
from the mean value for the group.
• In statistics, the standard deviation is a measure of the amount of
variation or dispersion of a set of values. A low standard deviation
indicates that the values tend to be close to the mean of the set, while a
high standard deviation indicates that the values are spread out over a
wider range.
• The standard deviation measures the spread of the data about the mean
value. It is useful in comparing sets of data which may have the same
mean but a different range. For example, the mean of the following two is
the same: 15, 15, 15, 14, 16 and 2, 7, 14, 22, 30.
Expected Return vs Standard Deviation
• Expected return and standard deviation are two statistical measures
that can be used to analyze a portfolio. The expected return of a
portfolio is the anticipated amount of returns that a portfolio may
generate, whereas the standard deviation of a portfolio measures the
amount that the returns deviate from its mean.
• For example, a portfolio has three investments with weights of 35% in
asset A, 25% in asset B and 40% in asset C. The expected return of
asset A is 6%, the expected return of asset B is 7%, and the expected
return of asset C is 10%. Therefore, the expected return of the
portfolio is 7.85% (35%*6% + 25%*7% + 40%*10%).
 Compounded Annual Growth Rate (CAGR)
• Compound annual growth rate (CAGR) is the rate of return that would
be required for an investment to grow from its beginning balance to
its ending balance, assuming the profits were reinvested at the end of
each year of the investment’s lifespan.
 How to calculate CAGR ?

To calculate the CAGR of an investment:

1.Divide the value of an investment at the end of the period by its value at the beginning of that period.
2.Raise the result to an exponent of one divided by the number of years.
3.Subtract one from the subsequent result.
 Example of CAGR Calculation
• Imagine you invested Rs10,000 in a portfolio with the returns outlined
below:
• From Jan 1, 2014, to Jan 1, 2015, your portfolio grew to Rs13,000 (or
30% in year one).
• On Jan 1, 2016, the portfolio was Rs 14,000 (or 7.69% from Jan 2015 to
Jan 2016).
• On Jan 1, 2017, the portfolio ended with Rs 19,000 (or 35.71% from Jan
2016 to Jan 2017).
• We can see that on an annual basis, the year-to-year growth rates of the
investment portfolio were quite different as shown in the parenthesis.
 CAGR Calculation (Contd)
• On the other hand, the compound annual growth rate smooths the
investment’s performance and ignores the fact that 2014 and 2016
were so different from 2015. The CAGR over that period was 23.86%
and can be calculated as follows:

The compound annual growth rate of 23.86% over the three-year investment period can help an
investor compare alternatives for their capital or make forecasts of future values. For example, imagine
an investor is comparing the performance of two investments that are uncorrelated. In any given year
during the period, one investment may be rising while the other falls. This could be the case when
comparing high-yield bonds to stocks, or a real estate investment to emerging markets. Using CAGR
would smooth the annual return over the period so the two alternatives would be easier to compare.
 Risk and Return on Debt Securities
• There are two components of debt fund returns – price appreciation
and rate of interest on the investment (commonly referred to as
coupon, payable on the principal amount)
• The price appreciation in debt securities is sensitive to movement in
interest rate.
• When interest rates increase, the prices of debt securities decrease
and vice versa.
• When interest rates increase, the prices of debt securities decrease
and vice versa. Any debt investment is exposed to various risks,
prominent ones being credit risk and interest rate risk.
 Credit Risk vs Interest Rate Risk
• Credit risk is the risk of a decline in credit worthiness of the borrower or
his default.
• Interest rate risk is the change in prices of the debt security on account
of the increase in interest-rates.
• The relationship between rate of interest on principal amount and the
market price of the debt security is captured by a metric called the yield
• It should be noted that yield is not the all-encompassing statistic for
debt funds.
• Reinvestment risk occurs because of a fall in interest rates at the time of
reinvestment
 Inflation Risk
• Inflation risk, also called purchasing power risk, is the chance that the cash flows from an
investment won't be worth as much in the future because of changes in purchasing power due to
inflation.
• Rs2,000,000 in bonds with a 10% coupon might generate enough interest payments for a retiree
to live on, but with an annual 6% inflation rate, every Rs 1,000 produced by the portfolio will only
be worth Rs 940 next year and about Rs 880 the year after that. The rising inflation means that the
interest payments have less and less purchasing power. And the principal, when it is repaid after
several years, will buy substantially less than it did when the investor first purchased the bonds.
• Some securities attempt to address this risk by adjusting their cash flows for inflation to prevent
changes in purchasing power
• Convertible bonds also offer some protection because they sometimes trade like bonds and
sometimes trade like stocks.
• It is important to note that inflation risk isn't the risk that there will be inflation, it is the risk that
inflation will be higher than expected.
 Re investment Risk
• Reinvestment risk refers to the possibility that an investor will be unable to
reinvest cash flows (e.g., coupon payments) at a rate comparable to their current
rate of return. Zero-coupon bonds are the only fixed-income security to have no
investment risk since they issue no coupon payments.
• Reinvestment risk is the likelihood that an investment's cash flows will earn less in
a new security.
• Reinvestment risk is the likelihood that an investment's cash flows will earn less in
a new security. For example, an investor invests in 5 Year FD for Rs100,000 with an
interest rate of 7%. The investor expects to earn Rs7,000 per year from the
security.
• However, at the end of the term, interest rates are 5.5%. If the investor invests
another Rs100,000 in FD, they will earn Rs 5500 annually rather than Rs 7,000.
Capital Asset Pricing Model (CAPM)
• The Capital Asset Pricing Model (CAPM) describes the relationship
between systematic risk and expected return for assets, particularly
stocks.
• CAPM is widely used throughout finance for pricing risky securities
and generating expected returns for assets given the risk of those
assets and cost of capital.
How to Calculate Expected Return under
CAPM
• The formula for calculating the expected return of an asset given its risk is as follows:
ERi​=Rf​+βi​( ERm​−Rf​)
Where: ERi​=expected return of investment
Rf​=risk free rate
βi​=beta of the investment
(ERm​−Rf​)=market risk premium​
• The beta of a potential investment is a measure of how much risk the investment will add to
a portfolio that looks like the market. If a stock is riskier than the market, it will have a beta
greater than one. If a stock has a beta of less than one, the formula assumes it will reduce
the risk of a portfolio.
• The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk
and the time value of money are compared to its expected return.
Use the CAPM formula to find out expected
value of a stock
• For example, imagine an investor is contemplating a stock worth Rs 100 per
share today that pays a 5 % annual dividend. The stock has a beta compared
to the market of 1.3, which means it is riskier than a market portfolio. Also,
assume that the risk-free rate is 7% and this investor expects the market to
rise in value by 12 % per year.
• The expected return of the stock based on the CAPM formula is 11.5%:
11.5%=5%+1.3×(12%−7%)​
• The expected return of the CAPM formula is used to discount the expected
dividends and capital appreciation of the stock over the expected holding
period. If the discounted value of those future cash flows is equal to Rs 100
then the CAPM formula indicates the stock is fairly valued relative to risk.
CAPM explained graphically
• The CAPM can be graphically expressed in the form of security market line (SML).
• The SML shows the trade-off between risk and expected return as a straight line
which intersects the vertical axis at risk-free rate. CAPM is the equation of the
SML which shows the relationship between expected return and beta.
• The CAPM shows that the expected return on a particular asset depends on
three factors—the pure time value of money as measured by risk-free rate (RF),
the reward for bearing risk measured by market risk premium E(RM)−RF, and the
amount of systematic risk measured by βi.(Beta)
• The risk premium on a risky asset is proportional to its beta.
• CAPM can be used to estimate the discount rate for future cash flows
CAPM valuation of stocks in a graph

The required or expected rate of return on a stock is compared with the estimated rate of return.
If the required rate of return is greater than the estimated return, then the stock is overvalued or
vice versa. Underpriced stocks plot above the SML; overpriced stocks plot below the SML. The
difference between estimated return and expected return is referred to as stock’s expected alpha
or excess return. When alpha is positive, the stock is undervalued and when alpha is negative,
the stock is overvalued. If the alpha is zero, the stock is on the SML,
Index Model (Single Index Model) in Stock
valuation
• The Single Index Model (SIM) is an asset pricing model, according to
which the returns on a security can be represented as a linear
relationship with any economic variable relevant to the security. In
case of stocks, this single factor is the market return.
• The single-index model (SIM) is a simple asset pricing model to
measure both the risk and the return of a stock. The model has been
developed by William Sharpe in 1963 and is commonly used in the
finance industry.
Formula for Single Index Model

These equations show that the stock return is influenced by the market (beta), has a firm specific expected
value (alpha) and firm-specific unexpected component (residual). Each stock's performance is in relation to the
performance of a market index. Security analysts often use the SIM for such functions as computing stock
betas, evaluating stock selection skills, and conducting event studies.
Assumptions of Single Index Pricing Model
• The index model is based on the following:
• Most stocks have a positive covariance because they all respond similarly to macroeconomic
factors.
• However, some firms are more sensitive to these factors than others, and this firm-specific
variance is typically denoted by its beta (β), which measures its variance compared to the
market for one or more economic factors.
• Covariances among securities result from differing responses to macroeconomic factors. Hence,
the covariance of each stock can be found by multiplying their betas and the market variance:
• The single-index model assumes that once the market return is subtracted out the remaining
returns are uncorrelated
• To simplify analysis, the single-index model assumes that there is only 1
macroeconomic factor that causes the systematic risk affecting all stock returns and this
factor can be represented by the rate of return on a market index, such as the S&P 500.
Case Study on Risk Management
• https://www.isaca.org/resources/isaca-journal/issues/2020/volume-5
/how-fair-risk-quantification-enables
• Study the above case and make your presentations in class
Typification of Risk
 Types of Risk Management

1.Risk Avoidance – Avoidance of risk means withdrawing from a risk

scenario or deciding not to participate.
2.Risk Reduction – The risk reduction technique is applied to keep risk
to an acceptable level and reduce the severity of loss through.
3.Risk Transfer – Risk can be reduced or made more acceptable if it is
shared.
4.Risk Retention – When risk is agreed, accepted and accounted for in
budgeting, it is retained
 Risk Avoidance

• Refusal of Proposal – If due diligence reveals the contract risk to be too high
during the first stage of the contract life cycle, the company will simply
decline the contract as proposed.
• Renegotiation – When risk has increased during the course of the contract
life cycle, opportunities to review and renegotiate terms may be taken to
introduce new conditions that avoid new risk.
• Non-Renewal – At the end of the initial contract life cycle, the business may
decline to renew the contract if the risk is estimated as being too high.
• Cancellation – Where circumstances cause risk to increase beyond
acceptable levels during the course of the contract life cycle and outside of
the agreed renewal timeframe, cancellation clauses may be enacted.
 Risk Reduction

• Contract Negotiation – When necessary, renegotiation at later

contract life cycle stages can be effective in contract risk reduction,
including at the renewal stage. This should always be aimed toward
the mitigation of risk and the reduction of loss.
• Standardization – Creating a library of standardized terms, conditions
and clauses is an important method of contract risk reduction. It
ensures a cohesive approach by all personnel and enables teams to
author contracts with the confidence of knowing that legal language
is pre-approved falls within the acceptable risk profile of the business.
 Risk Transfer

• The transfer or sharing of contract risk in contract management is

accomplished through due diligence on third parties and subsequent
outsourcing.
• This is an effective strategy for both manufacturing and service
provision businesses where certain aspects of the operation can be
contracted out to another company.
 Risk Retention

• Every time a business signs, renegotiates, or renews a contract, there is

an element of risk retention because every contract incurs risk at a
some level.
• All active contracts represent retention of contract risk, so it is
incumbent upon the business to incorporate this into risk management
planning, risk assessment processes, and the regular review of the risk
appetite and tolerance framework.
• By building the four types of risk management into a culture of
everyday best practices, commercial enterprises send a message to
third parties that they are safe to deal with
Categories of Risk ( Harvard Business
Review paper)
• Category I: Preventable risks: These are internal risks, arising from within the
organization, that are controllable and ought to be eliminated or avoided.
Examples are the risks from employees’ and managers’ unauthorized, illegal,
unethical, incorrect, or inappropriate actions and the risks from breakdowns in
routine operational processes.
• Category II: Strategy risks: A company voluntarily accepts some risk in order
to generate superior returns from its strategy. A bank assumes credit risk, for
example, when it lends money.
• Category III: External risks:Some risks arise from events outside the company
and are beyond its influence or control. Sources of these risks include natural and
political disasters and major macroeconomic shifts. External risks require yet
another approach.
Understanding the Three Categories of
Risk
• The risks that companies face fall into three categories, each of which
requires a different risk-management approach.
• Preventable risks, arising from within an organization, are monitored and
controlled through rules, values, and standard compliance tools.
• In contrast, strategy risks and external risks require distinct processes that
encourage managers to openly discuss risks and find cost-effective ways
to reduce the likelihood of risk events or mitigate their consequences.
• https://hbr.org/2012/06/managing-risks-a-new-framework
• Read the above article and send individual presentations on your
findings
 Probabilistic foundations of financial modelling and pricing

• When we work on a financial model, we face issues with variables that are uncertain or hard to
estimate with the required degree of accuracy.
• An example can be the expected returns of a stock.
• We have only historical data to base our estimates on, and there is significant volatility involved.
Therefore, estimating just one value for the stock return is a bad idea and can lead to significant
flaws in our model.
• To mitigate that, we can run Monte Carlo simulations and use random values for the stock return
variable. However, for astock with a current return of 12%, we know that a value of zero is far less
likely than that of 13%, which means that we need to adjust the randomness with this higher
likelihood.
• To be able to calculate such random values, we need to be able to define the probability for different
values of the variable.
• We do that by fitting a probability distribution to the stock return and using it to calculate a random
number, based on the likelihood for each value.
 What is a Probability Distribution

• Probability distributions are statistical functions that describe all

possible values of a random variable and their likelihood, within a
specific range.
• These are a result of the data generating process of an occurrence or its
probability distribution function (PDF).
• When we add up the probabilities, they give a cumulative distribution
function (CDF), which start at 0 and end at 1 (total probability of all
values is always 1, or 100%).
• Different probability distributions have a different purpose and outline
different data generation processes.
 Discrete Distribution
• We have two six-sided dice.
• Each dice has a 1/6 probability associated with each side.
• If we throw the dice, we have one instance where we can have a result
of 2 (1 + 1), which has an occurrence chance of 1 over 36 (6 sides on
one dice multiplied by 6 sides on the second dice).
• We have two instances where we can have a total of 3 (1 + 2 and 2 +
1), with a probability of 2/36, and so on. If we continue, we get the
following distribution:
Probability Distribution
• It is easy to notice that rolling a combination of 2 (1 + 1) or 12 (6 + 6) is
far less likely than rolling a combination of 7 (1 + 6, 2 + 5, 3 + 4, 4 + 3,
5 + 2, 6 + 1). Rolling dice is a discrete distribution, while the normal
distribution is continuous. However, the distribution of combination
probabilities approximates the latter.
• We often use functions in finance.
• Most simple equations of the type y = f(x) we can plot in Excel
• And such visual representation usually helps with analysis.
• There is no limit to the ‘shape’ of a probability distribution. However,
more complex ones may not have an easy equation to define them
 Types of Probability Distributions

• In discrete distributions, a variable can only have specific predefined values.

An example is a coin that can only be heads or tails. A dice is another
example; it can take any integer between 1 and 6 but cannot end up at 4.8.
• In continuous distributions, on the other hand, variables can have any value,
with some distributions having range limitations. In finance, we also face
some monetary convention limits. As an example, a share price can be €
10.35 or € 10.36, but never € 10.355. Also, it can’t go below zero. These
limits bring the share price values closer to having a discrete distribution, but
in finance, we still consider such variables to be continuous. Examples are
prices, return rates, interest rates, exchange rates, and others.
 Probability Distributions in finance

• Binomial Distribution: We use this to model events with binary

outcomes.
• An example is the toss of a coin or an operation that can be either a
success or a failure.
• Each occurrence is independent of the previous.
• If we have n instances, there are n+1 possible outcomes
and 2^n possible paths to these outcomes.
• Binomial distributions are used a lot in valuing path-dependent
options.
• We can represent the probability of achieving x successes (tossing
heads x times) with the following formula:

• Where the parameters are:

• p – probability for each trial;
• x – number of successes;
• n – number of tests.
• Excel has it integrated – BINOM.DIST.
Value of Binomial Distribution
• The expected value for a binomial distribution (or the mean) is equal
to the number of trials multiplied by the probability for each trial:
• We calculate the variance as follows:
• The standard deviation of the distribution is the square root of the
variance:
• If we want to calculate a random value within a binomial distribution
for our financial model, we can use the following formula:
Other forms of probabilistic distribution
• Uniform Distribution - Every time you use the RAND or RANDBETWEEN
function in Excel, you are applying a uniform probability distribution to the
variable you are calculating.
• Poisson Distribution - Use the Excel function, POISSON.DIST. And
VLOOKUP
• Normal Distribution - Excel, using the NORM.DIST and NORM.INV
functions.
• Lognormal Distribution -Excel has a function that we can use instead –
LOGNORM.DIST.
• Beta Distribution: In Excel, we can calculate the Distribution Functions (PDF
and CDF) with the BETA.DIST function.
 VaR and Non-VaR measurements and analysis • Copulas

• Copula analysis: Copulas can be defined as a type of multivariate probability distribution with a
uniform transformation based on Sklar’s theorem
• The combination of the copula and the single variable distributions will create a legitimate
multivariate distribution useful in risk management
• Copula is a probability model that represents a multivariate uniform distribution, which examines
the association or dependence between many variables. A copula helps isolate the joint or
marginal probabilities of a pair of variables that are enmeshed in a more complex multivariate
system.
• A copula is a statistical method for understanding the joint probabilities of a multivariate
distribution.
• The word copula comes from the Latin for "link" or "tie" together, where the term is used in
linguistics to describe such linking words or phrases.
• Copulas are quite complex mathematical functions and require sophisticated algorithms and
computing power to be practical in real-world applications.
VaR and Non-VaR measurements and
analysis
• Practitioners and researchers have employed several techniques to
model risk.
• The following are a sample of those methods used in quantifying risk:
Extreme Value Theory (EVT)
Value-at-Risk (VaR)
Conditional Value-at-Risk
Scenario Analysis
 Extreme value theory
• Researchers define Extreme Value Theory (EVT) as a statistical
probability theory .
• Initially presented by Ronald Fisher and Leonard Tippet.
• Extreme Value theory entails the use of extreme value probability
distributions identified as type I, type II, and type III distributions.
• Typically, researchers combined extreme value theory with other risk
modeling methods such as Generalized Autoregressive Conditional
Heteroskedasticity (GARCH), Value at-Risk (VAR), or Copula
Analysis.
Value-at-risk (VaR) and Conditional value-
at-risk (CVaR).
• Value-at Risk (VaR) is a method measuring risk introduced and
popularized by J. P. Morgan.
• Researchers and practitioner state that VaR approaches identify a loss
event specified at a precise confidence interval.
• VaR has become somewhat of a standard metric within risk
management because of VaR’s ability to traverse multiple lines of
business within a single company.
• VaR's popularity also resides in the ability to describe Enterprise Risk
as a single number.