Risk measurement slide

Risk Measurement by Dr. Satyanrayan Pandey

1. By Dr. Satyanarayan Pandey Department of Management Studies BBMKU, Dhanbad Risk measurement

2. Risk management Risk management  is a crucial process used to make investment decisions. The process involves identifying and analyzing the amount of risk involved in an investment, and either accepting that risk or mitigating it.

3. Risk identification Every investment is fraught with risks . Investors must analyze the risks in asset classes like debt and equity and find out ways to minimize them. Risk management in investments is the process of identify, analyze and mitigate the uncertainties in the investment decision.

4. Risks in fixed income As investors are gradually looking at debt mutual funds as an alternative to bank fixed deposit, they should keep in mind that such funds from asset management companies have some risks . Debt funds have C redit risks , Interest rate risks and liquidity risks.

5. Credit Risk After investors invest in debt funds, the fund house collects all the money and invest in instruments like government bonds and corporate bonds . Government bonds have a sovereign guarantee and are even safer than bank fixed deposits. However, corporate debt paper carry very high credit risks.

6. Credit risk …. Credit risk takes into account whether the bond issuer is able to make timely interest payments and pay the principal amount at the time of maturity of the bond . If the issuer is unable to do so, then the particular bond is likely to default . Bonds issued by state-owned companies like  NTPC ,  ONGC ,  Coal India , etc., have high credit rating of AAA and carry a quasi-government guarantee . Investors should not invest in funds that have high exposure to companies having a large leverage.

7. Interest rate risk Any change in the price of a bond because of changes in the interest rate can affect investors. Higher the maturity profile of the fund, more prone it is to interest rate risk . In case of increasing interest rate scenario, it will be positive for funds having a shorter maturity profile . On the other hand, a falling interest rate scenario will be beneficial for those funds which have a longer maturity profile. So, if you invest in debt funds of mutual funds, align investment horizon with that of a fund, which will help to mitigate the interest rate risk.

8. Liquidity risk Investors should also look at liquidity risks of the funds, which means how quickly the fund manager can sell the particular paper in case of any downgrade. Corporate bond of high rated companies are more liquid than the lower rated paper. If the fund manager is selling the paper under pressure, then investors will suffer losses.

9. Reinvestment risk Fixed income investors also face reinvestment risks. If the interest rate falls and the bond matures, then the investor will not be able to reinvest the maturity amount for higher rates . Like equity funds, even debt funds are market-linked instruments and there is no assured returns or capital preservation.

10. Risk in equity Markets volatility remains the most important risk in equity investment either directly or through mutual funds . It can impact investments if stock prices fall steeply or remain down for a long period of time . Ideally, to beat market volatility investors should invest via systematic investment plans (SIPs) of mutual funds. Investors must take note of the fund manager, his long-term track record, asset management company, its philosophy, fund expenses and investment style.

11. Industry specific risk Equity investments also face industry specific risks and returns will suffer if the particular industry is going through a cyclical downturn . An investor should find out about the risks involved instead of just worrying about the returns. “ Our mindset is driven towards return and reward rather than risk and loss. And greed and fear is what finally determines your wealth or lack of wealth,” he says.

12. Methods of risk Measurement Some common method of measurement of risk are Standard deviation, Sharp ratio B eta , value at risk ( VaR ), Conditional value at risk ( CVaR ). R-squared

13. Standard Deviation Standard deviation measures the dispersion of data from its expected value. The standard deviation is used in making an investment decision to measure the amount of historical volatility associated with an investment relative to its annual rate of return . It indicates how much the current return is deviating from its expected historical normal returns . For example, a stock that has high standard deviation experiences higher volatility, and therefore, a higher level of risk is associated with the stock.

14. Sharpe ratio The Sharpe ratio measures performance as adjusted by the associated risks. This is done by removing the rate of return on a risk-free investment, such as a U.S. Treasury Bond, from the experienced rate of return. This is then divided by the associated investment’s standard deviation and serves as an indicator of whether an investment's return is due to wise investing or due to the assumption of excess risk.

15. Beta Beta is another common measure of risk . Beta measures the amount of systematic risk an individual security or an industrial sector has relative to the whole stock market . The market has a beta of 1, and it can be used to gauge the risk of a security. If a security's beta is equal to 1, the security's price moves in time step with the market. A security with a beta greater than 1 indicates that it is more volatile than the market. Conversely, if a security's beta is less than 1, it indicates that the security is less volatile than the market. For example, suppose a security's beta is 1.5. In theory, the security is 50 percent more volatile than the market.

16. Value at Risk ( VaR ) Value at Risk ( VaR )   is a statistical measure 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 percent VaR of $5 million. Therefore, the portfolio has a 10 percent chance of losing more than $5 million over a one-year period.

17. 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 0 to 100. According to Morningstar, a mutual fund with an R-squared value between 85 and 100 has a performance record that is closely correlated to the index A fund rated 70 or less typically does not perform like the index.

18. Thanks