In this paper we propose a new risk management framework that can evaluate the cost-risk tradeoff of alternative risk management strategies. Although there is ample theoretical support for risk management as an activity, common risk management approaches suffer serious problems:
Minimize Risk: Completely eliminating risk is expensive and impractical
Efficient Frontier: Can eliminate many poor risk management strategies but rarely gives a definitive optimal
strategy
Sharpe Ratio: Provides a cost-risk trade-off but the price of one unit of risk is arbitrary
Based on a recent empirical study, we propose a new cost-risk measure which directly values the impact of earnings per share and cash flow per share volatility.
This new approach will enable corporate CFOs and treasurers to make more robust risk management decisions and, critically, better defend those decisions internally and to the broader market.
This document discusses risk budgeting and active manager allocation for multi-asset class funds. It defines the different types of risks that can be budgeted (systematic, active, etc.) and how the majority of a fund's risk comes from its systematic/beta exposures rather than active risk. The document provides mathematical formulas for decomposing total fund risk and return. It also discusses methods for determining manager allocations based on information ratios and evaluating whether returns come from alpha or beta.
This document summarizes the investment approach of BakerAvenue Asset Management. They practice an actively managed, prudent approach to asset allocation by considering macroeconomic factors, fundamental analysis, and technical indicators. This allows them to raise cash and reduce risk exposure when markets become overvalued or show signs of weakness. They offer multiple portfolio strategies that pursue this prudent, pragmatic approach across asset classes like equities, fixed income, and alternatives.
This document discusses various methods of measuring risk, including variance, standard deviation, skewness, kurtosis, and the components of risk such as project-specific risk, competitive risk, industry risk, market risk, and international risk. It then discusses the capital asset pricing model (CAPM) and how it uses beta to measure non-diversifiable risk and translate that into an expected return. The document provides an example of estimating beta for Disney stock.
This document discusses risk analysis in capital budgeting. It defines risk as the variation between actual and expected cash flows from a project. There are three main types of risk: stand-alone, portfolio, and market risk. The sources of risk include project-specific risks, competitive risks, industry risks, and international risks. Specific industry risks mentioned are technological risks, commodity risks, and legal risks. The document outlines various methods that can be used to incorporate risk into capital budgeting decisions, including adjusting the discount rate and using certainty equivalents, sensitivity analysis, and probability distributions.
The document discusses ratio analysis and various types of financial ratios used to analyze the financial performance and position of a company. It defines key liquidity ratios like current ratio and quick ratio. It also explains leverage ratios such as debt-equity ratio and total debt ratio that measure the use of debt financing. Further, it covers activity ratios including inventory turnover ratio and debtors' turnover ratio that assess efficiency of inventory and receivables management. The document emphasizes the importance of ratio analysis and interpretation of ratios with industry benchmarks.
Return and risk of portfolio with probabilityshijintp
This document outlines a study on predicting the return and risk of individual securities and portfolios. It discusses the objectives, methodology, variables, and limitations of the study. Regression analysis and probability assumptions are used to predict future security returns under various economic scenarios. The Sharpe model is applied to construct an optimal two-stock portfolio of Raymond and Axis Bank with an expected return of 28.14% and risk of 4.26%. The study demonstrates using historical data and fundamental analysis to estimate future security performance and portfolio risk-return.
Financial Management: Risk and Rates of Returnpetch243
This document discusses risk and rates of return in investments. It defines different types of risk like stand-alone risk and portfolio risk. It shows how to calculate expected returns, standard deviation as a measure of risk, and the coefficient of variation to compare risk-adjusted returns. It introduces the Capital Asset Pricing Model (CAPM) and how it uses beta to measure non-diversifiable market risk and determine required rates of return based on the security market line. It provides examples of calculating betas, expected returns, and portfolio risk measures like standard deviation and required returns.
The document discusses the relationship between risk and return, known as the risk-return nexus. It defines key concepts like risk, return, systematic and unsystematic risk. It explains that total risk is comprised of systematic and unsystematic risk, but that unsystematic risk can be diversified away. The Capital Asset Pricing Model (CAPM) asserts that the expected return of an asset depends only on its systematic risk. Empirical analysis of CAPM shows strong correlation between market returns and the returns of various bonds, supporting the model.
This document discusses risk budgeting and active manager allocation for multi-asset class funds. It defines the different types of risks that can be budgeted (systematic, active, etc.) and how the majority of a fund's risk comes from its systematic/beta exposures rather than active risk. The document provides mathematical formulas for decomposing total fund risk and return. It also discusses methods for determining manager allocations based on information ratios and evaluating whether returns come from alpha or beta.
This document summarizes the investment approach of BakerAvenue Asset Management. They practice an actively managed, prudent approach to asset allocation by considering macroeconomic factors, fundamental analysis, and technical indicators. This allows them to raise cash and reduce risk exposure when markets become overvalued or show signs of weakness. They offer multiple portfolio strategies that pursue this prudent, pragmatic approach across asset classes like equities, fixed income, and alternatives.
This document discusses various methods of measuring risk, including variance, standard deviation, skewness, kurtosis, and the components of risk such as project-specific risk, competitive risk, industry risk, market risk, and international risk. It then discusses the capital asset pricing model (CAPM) and how it uses beta to measure non-diversifiable risk and translate that into an expected return. The document provides an example of estimating beta for Disney stock.
This document discusses risk analysis in capital budgeting. It defines risk as the variation between actual and expected cash flows from a project. There are three main types of risk: stand-alone, portfolio, and market risk. The sources of risk include project-specific risks, competitive risks, industry risks, and international risks. Specific industry risks mentioned are technological risks, commodity risks, and legal risks. The document outlines various methods that can be used to incorporate risk into capital budgeting decisions, including adjusting the discount rate and using certainty equivalents, sensitivity analysis, and probability distributions.
The document discusses ratio analysis and various types of financial ratios used to analyze the financial performance and position of a company. It defines key liquidity ratios like current ratio and quick ratio. It also explains leverage ratios such as debt-equity ratio and total debt ratio that measure the use of debt financing. Further, it covers activity ratios including inventory turnover ratio and debtors' turnover ratio that assess efficiency of inventory and receivables management. The document emphasizes the importance of ratio analysis and interpretation of ratios with industry benchmarks.
Return and risk of portfolio with probabilityshijintp
This document outlines a study on predicting the return and risk of individual securities and portfolios. It discusses the objectives, methodology, variables, and limitations of the study. Regression analysis and probability assumptions are used to predict future security returns under various economic scenarios. The Sharpe model is applied to construct an optimal two-stock portfolio of Raymond and Axis Bank with an expected return of 28.14% and risk of 4.26%. The study demonstrates using historical data and fundamental analysis to estimate future security performance and portfolio risk-return.
Financial Management: Risk and Rates of Returnpetch243
This document discusses risk and rates of return in investments. It defines different types of risk like stand-alone risk and portfolio risk. It shows how to calculate expected returns, standard deviation as a measure of risk, and the coefficient of variation to compare risk-adjusted returns. It introduces the Capital Asset Pricing Model (CAPM) and how it uses beta to measure non-diversifiable market risk and determine required rates of return based on the security market line. It provides examples of calculating betas, expected returns, and portfolio risk measures like standard deviation and required returns.
The document discusses the relationship between risk and return, known as the risk-return nexus. It defines key concepts like risk, return, systematic and unsystematic risk. It explains that total risk is comprised of systematic and unsystematic risk, but that unsystematic risk can be diversified away. The Capital Asset Pricing Model (CAPM) asserts that the expected return of an asset depends only on its systematic risk. Empirical analysis of CAPM shows strong correlation between market returns and the returns of various bonds, supporting the model.
Ratio analysis ppt @ bec doms bagalkot mbaBabasab Patil
Ratio analysis involves calculating financial ratios to evaluate key aspects of a business's performance, including liquidity, investment potential, financial leverage, profitability, and asset efficiency. The ratios are grouped into five main areas and can identify strengths and weaknesses to aid decision making. Common ratios include the current ratio and acid test for liquidity, return on capital employed for profitability, and stock and debtor turnover for asset efficiency.
The document discusses various techniques for handling risk in capital budgeting decisions, including sensitivity analysis, simulation, and adjusting discount rates. Sensitivity analysis involves analyzing how changes in variables impact NPV or IRR. Simulation uses probability distributions and random numbers to estimate outcomes. Risk-adjusted discount rates increase the discount rate used based on a project's perceived risk level.
Equity Risk Premium in an Emerging Market Economyiosrjce
The finance literature suggests that in almost any kind of investing, returns would at least have some
relationship with risk-free rate of return (Rf), with investors demanding higher returns for greater risk. Risk-free
asset is regarded as one where the investor knows the expected return with certainty. This leads to the notion of
Equity Risk Premium (ERP), the extra return that, as compensation for the additional borne risk, the investor
earns over the Rf
, typically taken as 91-day Treasury bills (TB) rate of return. While similar studies have been
performed in the past, the applicability of the ERP concept across financial markets and its economic
implications as a risk measure has remained a contentious issue in the field, particular in emerging markets.
The present study seeks to revisit the issue in the Nigerian context based on secondary data spanning 2000-
2011. The statistical analysis based on the capital asset pricing model shows that the country’s Rf proxied by
TBs, had over the years traded at significantly higher levels of return than obtainable from market portfolio,
thus creating a negative ERP phenomenon. The implications of this peculiarity for sustainable wealth creation,
business development and valuation practice, are highlighted. Recent changes in the country’s Administration
makes this study even more relevant, thus, the paper also renews the call for creating a more pro-industry fiscal
policy climate if the national aspiration for sustainable inclusive growth is to be attained.
The document discusses decentralized investment management involving multiple investment managers. It begins by outlining the traditional model involving a single beneficiary and manager. It then explores reasons for employing multiple managers, including diversifying styles and judgments. The key assumptions and approaches are presented, including how managers' predictions can be blended optimally. Separating active and passive components allows clients to determine how aggressively to weight managers' views. Relative performance objectives can further incentivize managers without requiring short positions. Overall, blending multiple managers' predictions in an optimal manner allows for diversification of both styles and judgments.
Original article from the Flevy business blog can be found here:
http://flevy.com/blog/whats-the-impact-of-ratios-in-financial-analysis/
Financial statement analysis can be referred as a process of understanding the risk and profitability of a company by analyzing reported financial info, especially annual and quarterly reports. In other words, financial statement analysis is a study about accounting ratios among various items included in the balance sheet.
Advantages of Financial Statement Analysis
The different advantages of financial statement analysis are listed below:
The most important benefit if financial statement analysis is that it provides an idea to the investors about deciding on investing their funds in a particular company.
Another advantage of financial statement analysis is that regulatory authorities can ensure the company following the required accounting standards.
Financial statement analysis is helpful to the government agencies in analyzing the taxation owed to the firm.
Above all, the company is able to analyze its own performance over a specific time period.
From the above, it is obvious that only way for financial analysis is ratio analysis.
What is Ratio analysis?
What is the role/Importance of ratio analysis in financial analysis?
What are its advantages?
How it helps out in decision making?
How it helps the auditor in assessment of the risk of material misstatement?
These are some questions the answer of each must be known by every professional, business man and by user of financial statement. Some of you may already know about these. The answer of these questions must be part of professional’s life and business man must know to keep check on the management progress.
In simple words, we can say that ratio analysis is “quantitative analysis of information contained in a company’s financial statements.” In fact, it is critical quantitative analysis.
This document discusses risk analysis in investment. It defines risk as the potential for losing value and discusses different types of risk like financial risk and project-specific risk. It also outlines various techniques used for risk analysis like sensitivity analysis, probability distribution approach, and payback period. As an example, it shows how adjusting the discount rate for risk can impact a project's net present value. Overall, the document provides an overview of risk analysis in investments, outlining key concepts like different risk types and techniques used to evaluate risk.
- The document discusses various techniques for analyzing risk in capital budgeting decisions such as payback period, certainty equivalent, risk-adjusted discount rate, sensitivity analysis, scenario analysis, and simulation analysis.
- It also covers using decision trees for sequential investment decisions and incorporating utility theory to explicitly include a decision-maker's risk preferences in the capital budgeting analysis.
This document discusses how a portfolio manager can use Barra Aegis software to optimize his portfolio based on research scores from analysts. It describes converting qualitative research scores into quantitative expected returns or "alphas" based on an asset's volatility and forecasting skill. A case study illustrates how the portfolio manager analyzes his current portfolio's risks, sets optimization constraints, and generates an optimized portfolio with higher expected returns while meeting his investment guidelines. Converting scores into alphas that account for individual asset risk allows the optimization to better align the portfolio with the manager's views and minimize unintended risks.
Cost of capital is the minimum rate of return that a firm must earn on its investments to satisfy its investors. It incorporates the costs of different sources of capital like debt, equity, and preference shares. The cost of capital is used as a hurdle rate in capital budgeting - projects must earn more than the cost of capital to be accepted. It is also used to calculate economic value added and in leasing vs purchasing decisions. The cost of capital represents the minimum return required by investors given the risk of the firm's operations and financial structure. It is a key consideration in investment evaluation, debt policy design, and assessing management performance.
Ratio analysis is used to evaluate the financial performance and health of a business. Ratios show the mathematical relationship between two related figures and can be used for trend analysis and comparisons between firms. There are several types of ratios including liquidity ratios that measure short-term financial strength, activity/turnover ratios that measure efficiency, and profitability ratios. Current ratio, quick ratio, and inventory turnover ratio are some examples discussed. Ratios should be interpreted both individually and in comparison to past ratios and industry standards to evaluate performance over time.
This document discusses risk and return analysis for equity shares. It defines risk as the possibility of the actual outcome differing from the expected outcome, and return as the reward for undertaking an investment. It discusses calculating return using techniques like net asset value and calculating risk using statistical methods like standard deviation. Equity shareholders take on risk but can potentially earn profits. The relationship between higher risk and higher potential returns is also covered.
Visualizing the Effects of Holding Period and Data Window on Calculations of ...Ralph Goldsticker
This presentation shows how to use Cumulative Contribution Charts to visualize the relationships between investment horizon and volatility and the behavior of volatilities and correlations through time. With that information the researcher can select the sampling period and window that reflects the investment horizon and expected market environment.
This weeks paper addresses steps to overcome the retirement income challenge.
For retirees, investing in fixed income simply may not fulfill income or risk management needs, while investing heavily in equities may expose these investors to untimely amounts of risk. As Americans face this retirement income challenge, it is no wonder that portfolio longevity is now of greater concern than public speaking.
This document discusses risk management practices for hedge funds. It notes that risk management approaches differ across hedge funds based on their strategies. Common risk management tools discussed include Value at Risk (VaR), stress testing, concentration limits, drawdown management, and liquidity risk monitoring. The document cautions that no single risk management approach is best and that risk measures have limitations but can still provide useful insights if used appropriately.
The document discusses various financial ratios used to analyze a company's profitability, liquidity, efficiency, gearing, and evaluate investments. It provides examples and definitions of key ratios including gross profit margin, net profit margin, current ratio, acid test (quick) ratio, return on capital employed, stock turnover, gearing ratio, and average rate of return.
Assessing risk in a business has a lot to do with understanding the business' gearing (or leverage) ratio. This presentation takes highlights what you need to look for when analysing the ratio and some of the adjustments that sometimes have to be made.
Strategic asset allocation involves defining portfolio allocations based on long-term historical performance and volatility data, aiming to achieve the optimal balance of risk and return. Tactical asset allocation takes a similar long-term strategic view but allows flexibility to adjust allocations in response to short-term market conditions. While tactical allocation seeks to generate higher returns, it involves ongoing costs and research and there is no guarantee of outperformance. Ultimately, both approaches have merits and the choice depends on an investor's preferences and willingness to take on additional costs and risks of a tactical approach.
The document discusses various techniques for risk analysis in capital budgeting including probability, variance, coefficient of variation, payback period, risk-adjusted discount rate, certainty equivalent, sensitivity analysis, scenario analysis, simulation analysis, decision trees, and utility theory. It provides details on how to apply each technique and highlights their benefits and limitations.
The use of risk management products has grown tremendously in recent years and companies now employ large numbers of risk managers. A fundamental notion underlying these risk management practices is that cash flow and earnings volatility are harmful to shareholders—that is, these measures of volatility have a direct impact on the company’s stock price. If so, risk management tools that lower this volatility will benefit shareholders by raising the company’s stock price. In designing risk management programs, therefore, it is essential that managers have an understanding of the degree to which the market rewards the company’s stock price when cash flow and earnings volatility are lower. That is, CFOs need a market-
based measure of the benefits of reducing volatility through risk management practices.
In this paper, we provide evidence on whether companies with lower volatility are more highly valued than those with greater volatility. Our main findings are as follows:
Valuation multiple is substantially higher for companies with lower earnings per share (EPS) volatility. For example, a movement from the 75th percentile of EPS volatility to the 25th percentile increases the observed market-to-book (M-B) ratio from 1.15 to 1.32 (i.e., an increase of 15%).
Similarly, valuation multiple is significantly higher for companies with lower cash flow volatility. For example, a movement from the 75th percentile of cash flow volatility to the 25th percentile increases the observed market-to-book (M-B) ratio from 1.21 to 1.23.
Once we control for other determinants of the M-B ratio in a multivariate regression framework, we continue to find that cash flow volatility and earnings volatility have an economically meaningful impact on company value. All else equal, 10% reductions in EPS volatility and cash flow volatility are associated with increases in M-B ratios of 1.6% and 0.6%, respectively. Reductions in EPS volatility and cash flow volatility of 50% are associated with increases in M-B ratios of 11.2% and 4.0% respectively.
RISK-ACADEMY’s guide on risk appetite in non-financial companies. Free downloadAlexei Sidorenko, CRMP
Risk appetite refers to an individual or organization’s willingness to take on risks in pursuit of potential returns. It is an important consideration for businesses, as it can determine the types of investments and strategic decisions they make. A high risk appetite may lead to a focus on high-growth, speculative investments, while a low risk appetite may result in a preference for more conservative, steady returns. It is important for businesses to carefully assess and manage their risk appetite in order to make informed decisions and achieve their financial goals.
But before beginning the conversation about risk appetite, it is important to remember that most non financial organizations have already documented their appetites for different common decisions or business activities. Segregation of duties, financing and deal limits, vendor selection criteria, credit limits, treasury limits on banks, investment criteria, zero tolerance to fraud or safety risks – are all examples of how organizations set risk appetite.
What is risk appetite:
10% of the time risk appetite is imposed by laws and regulations, not set – Often risk appetite is imposed by government, regulators, markets, not set by management. Examples include zero-tolerances or limits on safety, bribery and corruption, AML, pollution, sanctions, privacy.
10% of the time risk appetite is the gentlemen’s agreement between Board and management – Boards have an important oversight role and help them set the direction and boundaries for management decision making. Those management decision making boundaries is risk appetite. Examples include deal approvals only by Board above a certain limit, limits on holding percentage of cash in certain pre-approved banks, market risk limits, credit risk limits, insurance thresholds, rules on credit limits for certain types of customers, limits on investments in different countries, etc.
80% of the time risk appetite is the risk reward trade-off for a specific decision – The key is making uncertainty around decisions presented to the Board transparent to allow decision makers choose the alternative which offers the most appropriate risk reward balance according to their individual appetites.
Download the full guide to read about documenting risk appetite, reviewing risk appetite, case studies and examples and addition video resources: Guide to risk appetite 2023
Ratio analysis ppt @ bec doms bagalkot mbaBabasab Patil
Ratio analysis involves calculating financial ratios to evaluate key aspects of a business's performance, including liquidity, investment potential, financial leverage, profitability, and asset efficiency. The ratios are grouped into five main areas and can identify strengths and weaknesses to aid decision making. Common ratios include the current ratio and acid test for liquidity, return on capital employed for profitability, and stock and debtor turnover for asset efficiency.
The document discusses various techniques for handling risk in capital budgeting decisions, including sensitivity analysis, simulation, and adjusting discount rates. Sensitivity analysis involves analyzing how changes in variables impact NPV or IRR. Simulation uses probability distributions and random numbers to estimate outcomes. Risk-adjusted discount rates increase the discount rate used based on a project's perceived risk level.
Equity Risk Premium in an Emerging Market Economyiosrjce
The finance literature suggests that in almost any kind of investing, returns would at least have some
relationship with risk-free rate of return (Rf), with investors demanding higher returns for greater risk. Risk-free
asset is regarded as one where the investor knows the expected return with certainty. This leads to the notion of
Equity Risk Premium (ERP), the extra return that, as compensation for the additional borne risk, the investor
earns over the Rf
, typically taken as 91-day Treasury bills (TB) rate of return. While similar studies have been
performed in the past, the applicability of the ERP concept across financial markets and its economic
implications as a risk measure has remained a contentious issue in the field, particular in emerging markets.
The present study seeks to revisit the issue in the Nigerian context based on secondary data spanning 2000-
2011. The statistical analysis based on the capital asset pricing model shows that the country’s Rf proxied by
TBs, had over the years traded at significantly higher levels of return than obtainable from market portfolio,
thus creating a negative ERP phenomenon. The implications of this peculiarity for sustainable wealth creation,
business development and valuation practice, are highlighted. Recent changes in the country’s Administration
makes this study even more relevant, thus, the paper also renews the call for creating a more pro-industry fiscal
policy climate if the national aspiration for sustainable inclusive growth is to be attained.
The document discusses decentralized investment management involving multiple investment managers. It begins by outlining the traditional model involving a single beneficiary and manager. It then explores reasons for employing multiple managers, including diversifying styles and judgments. The key assumptions and approaches are presented, including how managers' predictions can be blended optimally. Separating active and passive components allows clients to determine how aggressively to weight managers' views. Relative performance objectives can further incentivize managers without requiring short positions. Overall, blending multiple managers' predictions in an optimal manner allows for diversification of both styles and judgments.
Original article from the Flevy business blog can be found here:
http://flevy.com/blog/whats-the-impact-of-ratios-in-financial-analysis/
Financial statement analysis can be referred as a process of understanding the risk and profitability of a company by analyzing reported financial info, especially annual and quarterly reports. In other words, financial statement analysis is a study about accounting ratios among various items included in the balance sheet.
Advantages of Financial Statement Analysis
The different advantages of financial statement analysis are listed below:
The most important benefit if financial statement analysis is that it provides an idea to the investors about deciding on investing their funds in a particular company.
Another advantage of financial statement analysis is that regulatory authorities can ensure the company following the required accounting standards.
Financial statement analysis is helpful to the government agencies in analyzing the taxation owed to the firm.
Above all, the company is able to analyze its own performance over a specific time period.
From the above, it is obvious that only way for financial analysis is ratio analysis.
What is Ratio analysis?
What is the role/Importance of ratio analysis in financial analysis?
What are its advantages?
How it helps out in decision making?
How it helps the auditor in assessment of the risk of material misstatement?
These are some questions the answer of each must be known by every professional, business man and by user of financial statement. Some of you may already know about these. The answer of these questions must be part of professional’s life and business man must know to keep check on the management progress.
In simple words, we can say that ratio analysis is “quantitative analysis of information contained in a company’s financial statements.” In fact, it is critical quantitative analysis.
This document discusses risk analysis in investment. It defines risk as the potential for losing value and discusses different types of risk like financial risk and project-specific risk. It also outlines various techniques used for risk analysis like sensitivity analysis, probability distribution approach, and payback period. As an example, it shows how adjusting the discount rate for risk can impact a project's net present value. Overall, the document provides an overview of risk analysis in investments, outlining key concepts like different risk types and techniques used to evaluate risk.
- The document discusses various techniques for analyzing risk in capital budgeting decisions such as payback period, certainty equivalent, risk-adjusted discount rate, sensitivity analysis, scenario analysis, and simulation analysis.
- It also covers using decision trees for sequential investment decisions and incorporating utility theory to explicitly include a decision-maker's risk preferences in the capital budgeting analysis.
This document discusses how a portfolio manager can use Barra Aegis software to optimize his portfolio based on research scores from analysts. It describes converting qualitative research scores into quantitative expected returns or "alphas" based on an asset's volatility and forecasting skill. A case study illustrates how the portfolio manager analyzes his current portfolio's risks, sets optimization constraints, and generates an optimized portfolio with higher expected returns while meeting his investment guidelines. Converting scores into alphas that account for individual asset risk allows the optimization to better align the portfolio with the manager's views and minimize unintended risks.
Cost of capital is the minimum rate of return that a firm must earn on its investments to satisfy its investors. It incorporates the costs of different sources of capital like debt, equity, and preference shares. The cost of capital is used as a hurdle rate in capital budgeting - projects must earn more than the cost of capital to be accepted. It is also used to calculate economic value added and in leasing vs purchasing decisions. The cost of capital represents the minimum return required by investors given the risk of the firm's operations and financial structure. It is a key consideration in investment evaluation, debt policy design, and assessing management performance.
Ratio analysis is used to evaluate the financial performance and health of a business. Ratios show the mathematical relationship between two related figures and can be used for trend analysis and comparisons between firms. There are several types of ratios including liquidity ratios that measure short-term financial strength, activity/turnover ratios that measure efficiency, and profitability ratios. Current ratio, quick ratio, and inventory turnover ratio are some examples discussed. Ratios should be interpreted both individually and in comparison to past ratios and industry standards to evaluate performance over time.
This document discusses risk and return analysis for equity shares. It defines risk as the possibility of the actual outcome differing from the expected outcome, and return as the reward for undertaking an investment. It discusses calculating return using techniques like net asset value and calculating risk using statistical methods like standard deviation. Equity shareholders take on risk but can potentially earn profits. The relationship between higher risk and higher potential returns is also covered.
Visualizing the Effects of Holding Period and Data Window on Calculations of ...Ralph Goldsticker
This presentation shows how to use Cumulative Contribution Charts to visualize the relationships between investment horizon and volatility and the behavior of volatilities and correlations through time. With that information the researcher can select the sampling period and window that reflects the investment horizon and expected market environment.
This weeks paper addresses steps to overcome the retirement income challenge.
For retirees, investing in fixed income simply may not fulfill income or risk management needs, while investing heavily in equities may expose these investors to untimely amounts of risk. As Americans face this retirement income challenge, it is no wonder that portfolio longevity is now of greater concern than public speaking.
This document discusses risk management practices for hedge funds. It notes that risk management approaches differ across hedge funds based on their strategies. Common risk management tools discussed include Value at Risk (VaR), stress testing, concentration limits, drawdown management, and liquidity risk monitoring. The document cautions that no single risk management approach is best and that risk measures have limitations but can still provide useful insights if used appropriately.
The document discusses various financial ratios used to analyze a company's profitability, liquidity, efficiency, gearing, and evaluate investments. It provides examples and definitions of key ratios including gross profit margin, net profit margin, current ratio, acid test (quick) ratio, return on capital employed, stock turnover, gearing ratio, and average rate of return.
Assessing risk in a business has a lot to do with understanding the business' gearing (or leverage) ratio. This presentation takes highlights what you need to look for when analysing the ratio and some of the adjustments that sometimes have to be made.
Strategic asset allocation involves defining portfolio allocations based on long-term historical performance and volatility data, aiming to achieve the optimal balance of risk and return. Tactical asset allocation takes a similar long-term strategic view but allows flexibility to adjust allocations in response to short-term market conditions. While tactical allocation seeks to generate higher returns, it involves ongoing costs and research and there is no guarantee of outperformance. Ultimately, both approaches have merits and the choice depends on an investor's preferences and willingness to take on additional costs and risks of a tactical approach.
The document discusses various techniques for risk analysis in capital budgeting including probability, variance, coefficient of variation, payback period, risk-adjusted discount rate, certainty equivalent, sensitivity analysis, scenario analysis, simulation analysis, decision trees, and utility theory. It provides details on how to apply each technique and highlights their benefits and limitations.
The use of risk management products has grown tremendously in recent years and companies now employ large numbers of risk managers. A fundamental notion underlying these risk management practices is that cash flow and earnings volatility are harmful to shareholders—that is, these measures of volatility have a direct impact on the company’s stock price. If so, risk management tools that lower this volatility will benefit shareholders by raising the company’s stock price. In designing risk management programs, therefore, it is essential that managers have an understanding of the degree to which the market rewards the company’s stock price when cash flow and earnings volatility are lower. That is, CFOs need a market-
based measure of the benefits of reducing volatility through risk management practices.
In this paper, we provide evidence on whether companies with lower volatility are more highly valued than those with greater volatility. Our main findings are as follows:
Valuation multiple is substantially higher for companies with lower earnings per share (EPS) volatility. For example, a movement from the 75th percentile of EPS volatility to the 25th percentile increases the observed market-to-book (M-B) ratio from 1.15 to 1.32 (i.e., an increase of 15%).
Similarly, valuation multiple is significantly higher for companies with lower cash flow volatility. For example, a movement from the 75th percentile of cash flow volatility to the 25th percentile increases the observed market-to-book (M-B) ratio from 1.21 to 1.23.
Once we control for other determinants of the M-B ratio in a multivariate regression framework, we continue to find that cash flow volatility and earnings volatility have an economically meaningful impact on company value. All else equal, 10% reductions in EPS volatility and cash flow volatility are associated with increases in M-B ratios of 1.6% and 0.6%, respectively. Reductions in EPS volatility and cash flow volatility of 50% are associated with increases in M-B ratios of 11.2% and 4.0% respectively.
RISK-ACADEMY’s guide on risk appetite in non-financial companies. Free downloadAlexei Sidorenko, CRMP
Risk appetite refers to an individual or organization’s willingness to take on risks in pursuit of potential returns. It is an important consideration for businesses, as it can determine the types of investments and strategic decisions they make. A high risk appetite may lead to a focus on high-growth, speculative investments, while a low risk appetite may result in a preference for more conservative, steady returns. It is important for businesses to carefully assess and manage their risk appetite in order to make informed decisions and achieve their financial goals.
But before beginning the conversation about risk appetite, it is important to remember that most non financial organizations have already documented their appetites for different common decisions or business activities. Segregation of duties, financing and deal limits, vendor selection criteria, credit limits, treasury limits on banks, investment criteria, zero tolerance to fraud or safety risks – are all examples of how organizations set risk appetite.
What is risk appetite:
10% of the time risk appetite is imposed by laws and regulations, not set – Often risk appetite is imposed by government, regulators, markets, not set by management. Examples include zero-tolerances or limits on safety, bribery and corruption, AML, pollution, sanctions, privacy.
10% of the time risk appetite is the gentlemen’s agreement between Board and management – Boards have an important oversight role and help them set the direction and boundaries for management decision making. Those management decision making boundaries is risk appetite. Examples include deal approvals only by Board above a certain limit, limits on holding percentage of cash in certain pre-approved banks, market risk limits, credit risk limits, insurance thresholds, rules on credit limits for certain types of customers, limits on investments in different countries, etc.
80% of the time risk appetite is the risk reward trade-off for a specific decision – The key is making uncertainty around decisions presented to the Board transparent to allow decision makers choose the alternative which offers the most appropriate risk reward balance according to their individual appetites.
Download the full guide to read about documenting risk appetite, reviewing risk appetite, case studies and examples and addition video resources: Guide to risk appetite 2023
Financial risk management ppt @ mba financeBabasab Patil
This document provides an overview of financial risk management. It discusses key concepts such as risk, risk stratification, risk management approaches, interest rate risk, and term structure theories. The key points are:
1. Financial risk management involves monitoring risks and managing their impact on a firm. It uses modern finance theories to balance risk taken with expected reward.
2. Risk can be stratified into known probabilities, known parameters but uncertain quantification, unknown causation/interactions, and undiscovered or unmanifested risks.
3. A risk management approach involves identifying, measuring, and adjusting risks through behavior changes, insurance, hedging, and other means. Managing core business risks internally and hedging economic risks
The document discusses various types of risks faced by financial institutions including market risk, liquidity risk, credit risk, and operational risk. It provides an overview of how to manage these risks through a generic risk management approach of identifying, prioritizing, classifying, quantifying, and mitigating risks. Dynamic hedging is discussed as a technique to manage risks from guarantees on investment products through regular adjustments of hedge positions.
The document provides guidance on investment analysis and project selection. It discusses measuring risk and return, using hurdle rates that account for risk, and choosing projects that provide returns above the hurdle rate. The capital asset pricing model is introduced as a method to estimate expected returns based on beta and the risk premium. Diversification and the market portfolio concept are also covered.
1. The document discusses factors that affect a company's dividend policy, including stability of earnings, the age of the corporation, liquidity of funds, extent of share distribution, needs for additional capital, trade cycles, and government policies.
2. Key factors mentioned are the nature of the business, availability of cash, ownership structure, financing requirements for expansion, business cycles, and changes in government regulations.
3. Stable earnings allow companies to more consistently predict savings and earnings to set dividend policy, while new companies often retain more earnings for expansion and older companies can establish clearer policies.
The evils of a single point estimate.
Traditionally, when estimating costs, project value, equity value or budgeting, one number is
generated – a single point estimate. There are many problems with this approach. In budget
work this point is too often given as the best the management can expect, but in some cases
budgets are set artificially low generating bonuses for later performance beyond budget
Book Recommendation: Waring, M. Barton. Pension Finance – Putting the Risks and Costs of Defined Benefit Plans Back under Your Control. New Jersey: John Wiley & Sons, Inc., 2012. Print
The document provides an overview of various topics to be covered in a stock analyst program, including portfolio performance, equity analysis techniques, macroeconomic analysis, valuation methodologies, investment styles, and key financial ratios. It discusses approaches like discounted cash flow valuation, comparable companies analysis, and precedent transactions. It also covers different investment strategies such as value investing, growth investing, and contrarian investing.
The document discusses various techniques for risk analysis in capital budgeting including probability, variance, coefficient of variation, payback period, risk-adjusted discount rate, certainty equivalent, sensitivity analysis, scenario analysis, simulation analysis, decision trees, and utility theory. It provides details on how to apply each technique and highlights their benefits and limitations.
Mercer Capital | Valuation Insight | Capital Structure in 30 MinutesMercer Capital
This document provides a guide for directors and shareholders on capital structure decisions. It discusses evaluating the optimal capital structure by identifying the financing mix that minimizes the weighted average cost of capital. While debt has a lower nominal cost than equity, the relevant consideration is the marginal cost of each, which is impacted by leverage levels. The document outlines measuring a company's current capital structure, comparing it to peers, identifying a target structure, and evaluating sources and uses of funds to move towards the target.
This document discusses risk and return in the context of a group assignment for a project cost accounting and financial management course. It begins by listing the names of the 8 students in the group and their professor. The bulk of the document then defines risk and return, discusses different types of risk and how to adjust for risk, and strategies for managing risk such as diversification and hedging. It provides examples and formulas to illustrate concepts around expected return, risk adjustment methods, and the relationship between risk and return for different investments.
This research paper discusses enhancing value investment strategies by incorporating expected profitability.
For small cap value strategies, the paper proposes excluding stocks in each country with the lowest direct profitability, with the percentage excluded depending on the stock's price-to-book ratio.
For large cap value strategies, the paper suggests selecting stocks based on both low price-to-book ratios and high direct profitability. It also proposes overweighting stocks that have higher profitability, lower market capitalization, and lower relative price.
The goal is to structure portfolios to better capture the dimensions of expected returns related to company size, relative price, and expected profitability, while maintaining appropriate diversification and managing costs.
This document provides an introduction to enterprise risk management (ERM). It discusses how ERM aims to protect and increase value for an organization by taking an integrated approach to managing risks across the entire enterprise. ERM calls for high-level oversight of all risks on a portfolio basis. The document provides background on the evolution of risk management and outlines some of the key risks organizations face today from globalization and other factors. It also notes that chief risk officers and risk committees are important for overseeing ERM.
Measure What Matters - New Perspectives on Portfolio SelectionUMT
The document discusses new frameworks for IT portfolio selection that consider both financial and strategic metrics. It summarizes that traditional portfolio selection focused solely on financial metrics, but recent research shows this led to underinvestment in strategic areas. The new framework evaluates investments from four perspectives: demand, supply, governance, and alternatives. This allows executives to consider financial returns, strategic alignment, risk exposure, architectural fit, options, costs, deadlines, and skills. Successful companies now use multiple financial and strategic metrics to optimize resource allocation and maximize investment value and benefits.
Four Steps to Making Economic Capital Calculations an Engine for Business GrowthSecondFloor
Economic capital calculation is not only a journey to Solvency II compliance
This paper looks at why economic capital (EC) calculations are frequently under-used as a tool to drive business strategy, and why that amounts to a huge missed opportunity for insurance businesses of all sizes. It explores the barriers that prevent insurance businesses from using EC as a strategic tool to shape, strengthen and improve the business, and suggests a four-step process to ensuring that economic capital calculations become a vital planning resource for all areas of the business, including risk managenet, finance, underwritingm risk analysis.
Economic Capital Calculations for Insurances whitepaper refers to
The challenge for Risk Officers
Barrier # 1 No Common Language
Barrier # 2 Poorly Understood Risk Models
Barrier # 3 The Wrong Risk Models - Or Not Enough
The Trouble with Value at Risk (VaR): example
Four Steps to Meaningful Economic Capital Calculations
STEP 1: Sing from the same balance sheet
STEP 2: Speak English: bad karaoke is preferable to good silence
STEP 3: Agree on own funds and SCR and create a common risk dashboard
STEP 4: Build a chorale
Look to the Future: the challenge for insurance risk professionals.
In summary, the challenge for insurance risk professionals is to create an environment in which Economic Capital Calculations can be used by all lines of business to drive good decisions that protect policyholders and investors while enabling safe and profitable growth (the essence of Pillar II of Solvency II). While few risk departments are fully capable of this today, some innovative firms share this vision and are working towards achieving it.
This document discusses best practices for enterprise risk management (ERM) from the perspective of a board of directors. It addresses five key dimensions of ERM: risk transparency and insight, risk appetite and strategy, risk-related processes and decisions, risk organization and governance, and risk culture. The document provides recommendations for boards to strengthen their company's risk management, including developing a prioritized risk heat map, understanding the company's "big bets," ensuring risk reports deliver clear and insightful information, defining the company's risk appetite, integrating risk insights into strategy, and focusing on building a strong risk culture. The document concludes by outlining 12 specific actions boards should take to lift their company to the highest standards of risk management.
65 of the paper needs to be cited with scholarly articles.Ther.docxssuser774ad41
65 % of the paper needs to be cited with scholarly articles.
There is no doubt that a solid compensation philosophy must address issues of equity and justice, both from an internal perspective and an external perspective. As such one must be very aware of the causes of inequity but also be much attuned to the relationships, internal and external, that promote concerns. A strong compensation program, driven by a philosophy of justice and equity, can define and placate problems before they occur.
Required Reading:
Please refer to the Activity Resources section of each activity for the required readings.
Assignment 4 Equity: Internal and External
As an HR professional, it is important to thoroughly understand the concept of internal and external equity in terms of pay and benefits. For example, you will need to understand how to answer the following questions. How is the concept of internal and external equity similar or different in discussing pay versus benefits? In the struggle to recruit and retain productive and motivated staff members, is it better to design and promote a compensation and benefit program that focuses on external market competitiveness or that is structured to promote internal equity? How does one articulate the concept of just and equitable within a compensation structure? Activity Resources:
HYPERLINK "http://proxy1.ncu.edu/login?url=http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=44900327&site=ehost-live" Earle, J. E. (2009).
Main Task: Analyze Issues of Internal and External Equity Write a paper analyzing the concepts of internal and external equity and apply these concepts to an examination of pay versus benefits in organizations. Include in the analysis, a comparison of the advantages and disadvantages in designing compensation and benefit programs that focus on external market competitiveness or that are structured to promote internal equity. Support your analysis based on current research incorporating three journal articles or publications into your response. Support your paper with minimum of five (5) scholarly resources. In addition to these specified resources, other appropriate scholarly resources, including older articles, may be included. Length: 5-7 pages not including title and reference pages Your paper should demonstrate thoughtful consideration of the ideas and concepts that are presented in the course and provide new thoughts and insights relating directly to this topic. Your response should reflect scholarly writing and current APA standards. Incorporate reference page number within the context of the paper. Use current day examples to substantiate your research. Submit your document in the Course Work area below the Activity screen. Learning Outcomes: 3, 4
Assignment Outcomes
Analyze the importance of balancing internal and external pressures and effects of external competitiveness in designing pay structures. Assess the role of performance measurement in compensation deci.
The document discusses strategies, tactics, and practices for managing risk and opportunity in commercial relationships. It addresses assessing risk through a strategic lens, defining core and non-core activities, and ensuring contracts address key risks. Tactics discussed include commitment management, applying best practices flexibly, and focusing on relationships over contracts alone. The benefits of risk resilience and its links to corporate governance are also covered.
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2. i Strategic Capital Advisory
Quantifying the Value of Risk Management
January2008
Acknowledgments
We would like to thank Michael Ondruska and Hans Tallis for their valuable comments. Of course, any
remaining errors are our own.
3. Strategic Capital Advisory ii
Quantifying the Value of Risk Management
January2008
Executive Summary
In this paper we propose a new risk management framework that can
evaluate the cost-risk tradeoff of alternative risk management strategies.
Although there is ample theoretical support for risk management as an
activity, common risk management approaches suffer serious problems:
Minimize Risk: Completely eliminating risk is expensive and
impractical
Efficient Frontier: Can eliminate many poor risk management
strategies but rarely gives a definitive optimal
strategy
Sharpe Ratio: Provides a cost-risk trade-off but the price of one
unit of risk is arbitrary
Based on a recent empirical study, we propose a new cost-risk measure which
directly values the impact of earnings per share and cash flow per share
volatility.
This new approach will enable corporate CFOs and treasurers to make more
robust risk management decisions and, critically, better defend those
decisions internally and to the broader market.
4. iii Strategic Capital Advisory
Quantifying the Value of Risk Management
January2008
Contents
Table of Contents
Evaluating Risk Management Policies 1
Traditional Approaches to Policy Evaluation 3
Minimize Risk 3
Minimize Value-at-Risk (VaR) 3
Efficient Frontier 3
The Sharpe Ratio and Related Measures 5
Summary of Traditional Approaches 7
A New Approach 8
Introduction 8
Application of the New Approach 10
Relationship with the Sharpe Ratio 11
Drawbacks of the New Approach 12
Conclusion 13
Table of Figures
Figure 1—Summary of Impact of Cash Flow Volatility on Company Value 1
Figure 2— Desirable Properties of a Policy Evaluation Mechanism 2
Figure 3— EPS Risk-Reward for Various Funding Strategies 4
Figure 4— Efficient Funding Strategies 4
Figure 5— Using Sharpe Ratio to Find Optimal Strategy 6
Figure 6—No Traditional Approaches are Satisfactory 7
Figure 7—Sensitivity of Firm Value to Changes in Volatility 8
Figure 8—Valuing Risk Management Initiatives 10
Figure 8— Using the New Approach to Find Optimal Strategy 12
Figure 9—The New Approach Improves Upon Traditional Methods 13
Table of Examples
Example 1 – Efficient Frontier Analysis for FakeCo. 3
Example 2 – Can Risk/Return Ratios Help? 6
Example 3 – Collapsing the Efficient Frontier 11
Example 4 – Tying it All Together 12
5. Strategic Capital Advisory 1
Quantifying the Value of Risk Management
January2008
Evaluating Risk Management Policies
In 1958 Modigliani and Miller advanced their famous value irrelevance theorem
which implied that, under perfect capital markets, neither capital structure nor
risk management policy impacts firm value. This provided a roadmap for future
researchers to examine the ways in which risk management could be value
relevant by examining how the effects of market imperfections are exacerbated
by volatility and uncertainty.
Well established arguments for the value relevance of risk management are
shown in Figure 1.
Figure 1—Summary of Impact of Cash Flow Volatility on Company Value
Factor
Highvolatility increases the probabilitythat a company will incur
costs associatedwithdistress—e.g., bankruptcy costs, lostsales, and
supplier problems
Consequence
Higher Expected
Costs of Financial
Distress
Highvolatility increases the probabilitythat a company will need
outside financing. Because external finance is costly, some profitable
projects may be bypassed
Foregone
Investment
Opportunities
Withprogressivetax schedules, highvolatility increasesexpected tax
payments
Higher Tax
Payments
Higher cashflow volatilityincreases the probability that earnings will
fall short of market expectations,leading to stockprice drop
Greater Probability
of Missed Earnings
Targets
However, less research has been conducted on quantifying how much value is
created by managing risk or on how to evaluate two risk management policies
and choose the ―best‖. In practice, most companies actively engage in risk
management, but with only subjective evaluation of the costs and benefits of this
activity.1
In this paper, we examine traditional approaches to risk management policy
evaluation, note their practical and theoretical drawbacks, and then propose a
new evaluation measure which we believe overcomes many of these drawbacks.2
We call a mechanism for evaluating a risk management policy a measure.
Figure 2 lays out the desirable properties of an ideal risk management measure.
1 This subjective evaluation may have a quantitative element. E.g., “We have reduced the standard deviation of our interest
expense from USD 100m to USD 75m, at a cost of USD 10m.” However, deciding if such a change is beneficial to the
company overall still requires a subjective judgment.
2 See our paper “Does Risk Management Create Value?” for a detailed discussion of the study from which the framework
presented in this paper is developed.
Qualitative arguments for
the value of risk
management are well
established and accepted…
…but less emphasis has been
placed on quantifying the
value of risk management
6. 2 Strategic Capital Advisory
Quantifying the Value of Risk Management
January2008
Figure 2— Desirable Properties of a Policy Evaluation Mechanism3
Definitive
Risk-Aware
Earnings-Aware3
Non-Arbitrary
Universal
Forany two risk management policies, alwaysprovide a clear
indicationof whichis preferable and by how much
Recognize the desirability of reduced risk
Recognize the desirability of increased earnings
Make risk-earnings trade off ina way that is broadly inline with
investorpreferences
Be applicable to operational and financial risks and to the entire firm
orany sub-unit of the firm
3 Risk management policies are often represented in terms of cost versus risk. In this paper, we use the broader concept of
earnings versus risk, since any cost impact can be translated into an earnings impact. Hence we are seeking to maximize
earnings and minimize risk.
7. Strategic Capital Advisory 3
Quantifying the Value of Risk Management
January2008
Traditional Approaches to Policy Evaluation
Minimize Risk
A firm could simply choose whichever policy gives the lowest risk as measured
by the standard deviation of earnings or some other dispersion metric. This is
sometimes valid at the sub-unit level if a risk has already been identified as
highly toxic. However, it is neither earnings-aware nor universal. If applied to
the entire firm it would suggest selling all operating assets and investing the
funds in risk-free securities, such as government bonds.
Minimize Value-at-Risk (VaR)
A firm could chose the policy with that gives the lowest VaR of earnings. This is,
at least, earnings-aware because moving the distribution to the right will reduce
VaR. However, the choice of level (e.g., 95%, 99%, etc.) and base makes this
approach arbitrary.4
Efficient Frontier
A very common approach, borrowed from portfolio management, is the
―efficient frontier‖. Here the risk and earnings5 of different policies are plotted on
a scatter diagram. A policy is deemed efficient only if there is no other policy
with the same risk and higher earnings or the same earnings and lower risk.
Example 1 provides an example of how this method is used in practice.
Example 1 – Efficient Frontier Analysis for FakeCo.
FakeCo. is a manufacturing firm based in the United States but with some
operations in the EuroZone. Currently, all FakeCo.’s debt is fixed rate and USD
denominated. The new CFO asks the firm’s treasurer to determine the firm’s
optimal currency mix and fixed-floating mix of debt.
First, the treasurer’s staff conducts a correlation analysis and determines that
USD operating income is positively correlated to USD interest rates and EUR
operating income is positively correlated to EUR interest rates. Additionally,
USD and EUR operating incomes are correlated and USD and EUR interest rates
are correlated, building out a full correlation matrix of the main drivers in this
analysis.
The Treasury team then runs a Monte-Carlo simulation of earnings per share for
different financial policies. Specifically, they vary three variables from 0% to
100%, in steps of 5%:
Proportion of debt in EUR
Proportion of USD debt that is floating rate
Proportion of EUR debt that is floating rate
This gives a total of 213 ≈ 9,300 possible risk management policies under
consideration – which the Treasury team considers representative of the policies
they might implement. Figure 3 depicts the expected EPS and the EPS risk of the
policies examined.
4 A comprehensive discussion of the shortcomings of VaR is beyond the scope of this paper. Please see Beder, Tanya Styblo,
1995, VaR: Seductive but Dangerous, Financial Analysts Journal.
5 Or equivalently, for this efficient frontier discussion, cash flows.
Although the efficient
frontier approach is
commonly used by
practitioners, there are a
number of difficulties with
this method, making it
inappropriate for optimizing
the tradeoff between
different risk management
policies
8. 4 Strategic Capital Advisory
Quantifying the Value of Risk Management
January2008
Figure 3— EPS Risk-Reward for Various Funding Strategies
1.00
1.05
1.10
1.15
1.20
0.10 0.12 0.14 0.16 0.18 0.20
ExpectedEPS($)
EPS Risk ($)
Most Desirable
Risk/Return Tradeoff
Least Desirable
Risk/Return Tradeoff
The Treasury team can now eliminate inefficient policies as shown in Figure 4.
Figure 4— Efficient Funding Strategies6
1.00
1.05
1.10
1.15
1.20
0.10 0.12 0.14 0.16 0.18 0.20
ExpectedEPS($)
EPS Risk ($)
Inefficient Portfolios
6 The curvature of the line connecting the efficient portfolios is predominantly driven by the respective positive correlations
between operations in the United States and the EuroZone and USD and EUR interest rates.
Inefficient portfolios may be
easy to identify, but there are
still a number of efficient
portfolios remaining, all of
which are considered
―optimal‖ from a risk-return
perspective
9. Strategic Capital Advisory 5
Quantifying the Value of Risk Management
January2008
The Treasurer now has 40 policies, all of which are ―optimal‖ using the efficient
frontier measure. Unfortunately, these policies cover a wide range of
possibilities, including:
Strategy
USD Fixed
Rate Debt
USD Floating
Rate Debt
EUR Fixed
Rate Debt
EUR Floating
Rate Debt
Min. Risk 0% 0% 100% 0%
Low Risk 0% 0% 85% 15%
High EPS 0% 50% 0% 50%
Max. EPS 0% 100% 0% 0%
The efficient frontier approach is valuable in so far as it can identify poor risk
management policies. However, it rarely gives a definitive answer since it does
not provide a measure of the value of one policy versus another.
The Sharpe Ratio and Related Measures
Another concept borrowed from asset management is the Sharpe ratio, which is
defined as:
)var
)E
f
f
R(R
R(R
S
where R = Return on the portfolio
Rf = Risk-free rate
When applied to corporate policies, the risk-free rate is often omitted and the
Sharpe ratio simply becomes the expected earnings divided by the standard
deviation of earnings. Example 2 illustrates how the Sharpe Ratio is commonly
used in risk management policy determination.
10. 6 Strategic Capital Advisory
Quantifying the Value of Risk Management
January2008
Example 2 – Can Risk/Return Ratios Help?
Continuing from Example 1, the Treasurer recalls the Sharpe ratio and is initially
optimistic that it resolves her dilemma. It can be applied to each risk
management policy and one policy will be the ―best‖. Equivalently, she can
draw equipreference or indifference lines that represent earnings-risk
combinations with the same Sharpe ratios. The point at which the first
equipreference line touches the efficient frontier is the optimal point.
Figure 5— Using Sharpe Ratio to Find Optimal Strategy
1.00
1.05
1.10
1.15
1.20
0.10 0.12 0.14 0.16 0.18 0.20
ExpectedEPS($)
EPS Risk ($)
Equipreference
Lines
Optimal
Strategy
On reflection, however, she realizes that she would be unwilling to stand in
front of the Board of Directors and defend her choice. Her concern is that this
methodology implicitly assumes that a 1% reduction in risk is as desirable as a
1% increase in earnings. Fundamentally, she isn’t sure that this risk-return
tradeoff is the same as the tradeoff that is priced in the marketplace.
Thus, the Sharpe Ratio fixes the main problem with the efficient frontier—it is at
least definitive. However, the price of a unit of risk is entirely arbitrary.
Although there are many variants of the Sharpe ratio, such as the Sortino ratio7,
they are all arbitrary in their assignment of the cost of a unit of risk.
7 The Sortino ratio uses a target rate in place of the risk free rate and the downside semi-variance instead of the variance.
Although the Sharpe Ratio
gives a unique optimal
policy, there is no reason to
believe that the risk-return
tradeoff assigned by the
Sharpe ratio has any
connection to that priced in
the marketplace
11. Strategic Capital Advisory 7
Quantifying the Value of Risk Management
January2008
Summary of Traditional Approaches
To put the relative attractiveness of each of the traditional evaluation approaches
in perspective, Figure 6 evaluates them against the desirable properties of a
policy evaluation mechanism outlined in Figure 2.
Figure 6—No Traditional Approaches are Satisfactory
Definitive Risk-Aware
Earnings-
Aware
Non-
Arbitrary
Universal
MinimizeRisk
MinimizeVaR
Efficient Frontier
Sharpe Ratio
½
½
½
As the above table demonstrates, unfortunately none of these traditional
approaches provides a satisfactory framework for making fully informed
decisions on risk management strategy.
12. 8 Strategic Capital Advisory
Quantifying the Value of Risk Management
January2008
A New Approach
Introduction
The largest drawback with existing measures is the arbitrary price associated
with each unit of risk. To overcome this, we conducted a study of the impact of
EPS volatility on valuation. To determine whether shareholders considered cash
flow only, or whether they place incremental informational value of earnings, we
also considered the volatility of cash flow per share (CFPS).
We found that, even after controlling for other determinants of value, such as
firm size and profitability, EPS and CFPS volatility negatively impact firm
valuation.8 The sensitivity of Market-to-Book (M-B) ratio to changes in the
volatility of earnings and cash flow are detailed below in Figure 7.
Figure 7—Sensitivity of Firm Value to Changes in Volatility
1.6%
3.5%
5.6%
8.1%
11.2%
0.6%
1.3%
2.1%
3.0%
4.0%
0%
3%
6%
9%
12%
15%
10% 20% 30% 40% 50%
% Increase in
M-B Ratio
% Reduction in Volatility
Earningsvolatility Cash flow volatility
2.2%
4.8%
11.3%
7.8%
15.7%
Mathematically, the results of our study can be summarized as:
cEc
B
M
log.log.log
05701530
where assetsofvaluemarketM
assetsofbook valueB
constantspecific-firmAc 9
shareperearningsquarterlyofVolatilityE
shareperflowcashquarterlyofVolatilityc
8 The full results are published in our recent paper “Does Risk Management Create Value?”
9 This constant is a function of several firm characteristics. Therefore, care should be taken to ensure this methodology is only
applied to policy changes that do not significantly impact these characteristics.
Both independently and
together, changes in EPS
volatility and changes in
CFPS volatility are associated
with changes in
M-B ratio
(1)
13. Strategic Capital Advisory 9
Quantifying the Value of Risk Management
January2008
A rearrangement leads to a formula for firm value in terms of book value of
assets, earnings volatility and cash flow volatility
05701530 ..
CEBkM
where )exp(ck
The constant c, and hence k, can be estimated in one of two ways. Either, using
the full regression equation presented in our previous paper or by reversing out
the constant using current or historical values for M, B, E and C :
05701530 ..
CE
B
M
k
Once we’ve estimated the constant, it is now possible to rearrange the results in
order to present them solely in terms of the proportional change in EPS and
CFPS volatility and not on the absolute starting level of M-B or volatility.
05701530 ..
Base
New
Base
New
C
C
E
E
Base
Base
New
New
B
M
B
M
Given these results, in practice we can estimate the expected value of any risk
management policy by following by:
(1) Calculating the firm-specific constant (k = exp(c))
(2) Calculating expected book value of assets (B) under the policy based on
expected earnings10
(3) Calculating the volatility of EPS ( E ) under the policy
(4) Calculating the volatility of CFPS ( C ) under the policy
(5) Evaluating the new implied market value of assets (M) calculated with
Equation 2
(6) Determining the implied market value of equity by subtracting the
market value of debt
These steps are presented diagrammatically in Figure 8 below.
10 Calculation of expected book value of assets requires an estimation of the policy’s effect on net earnings and therefore book
value of equity/assets (where book value of assets = book value of liabilities + book value of equity).
(2)
(3)
(4)
14. 10 Strategic Capital Advisory
Quantifying the Value of Risk Management
January2008
Figure 8—Valuing Risk Management Initiatives
Net Income
Book Value of
Assets
B
Earnings per
ShareVolatility
E
Cash Flow per
ShareVolatility
C
Firm-Specific
Factors
c
Implied Market
Value of Assets
M
Implied M/B Ratio
Implied Share Price
After going through the six steps for every strategy under examination, the
optimal policy can be determined by comparing the respective share price
implications.
Application of the New Approach
Under the new approach, we can trace the implications of any risk management
policy down into forecast earnings and cash flows and the volatility thereof.
Then, we can use forecasted earnings to determine the consequences for book
value of assets and equity and easily apply the framework to work out the
expected change in value if the policy were implemented.
The new approach folds the
tradeoff between cost and
risk of various strategies into
one critical number, the
impact on share price and
allows for much more clarity
in setting optimal risk
management policy
15. Strategic Capital Advisory 11
Quantifying the Value of Risk Management
January2008
Example 3 – Collapsing the Efficient Frontier
Continuing from Example 1, the Treasury team applies Equation (2) to each of
the roughly 9,300 risk management policies under consideration.11 They then put
the policies in order and find a single policy which is preferable to all others.
Strategy
Implied
Stock
Price
USD
Fixed Rate
Debt
USD
Floating
Rate Debt
EUR
Fixed Rate
Debt
EUR
Floating
Rate Debt
Optimal $20.00 0% 0% 85% 15%
Next Best $19.99 0% 0% 80% 20%
Max. EPS $19.37 0% 100% 0% 0%
Min. Risk $19.98 0% 0% 100% 0%
Current $18.99 100% 0% 0% 0%
The Treasurer can then confidently make the following statements:
The optimal policy is 85% EUR denominated fixed rate debt and 15%
EUR denominated floating rate debt
The next best policy is very similar to the optimal policy
The firm is destroying $1.01 ($20.00 - $18.99) per share of theoretical
shareholder value by not being at the optimal fixed floating and currency
mix
Relationship with the Sharpe Ratio
Although more complex in form than the Sharpe ratio, our new equation can
nevertheless be used to draw equipreference lines on an efficient-frontier
diagram. This is easiest if the equation is rearranged into12:
S
B
E
kS
M
E Base
BaseCE
05701530 ..
where shareperearningsE
goutstandinsharesS
11 Having already computed the efficient frontier they could apply equation (2) only to those points on the frontier. However,
because the equation is fast to compute, we typically apply it to every policy.
12 Assuming that SESEBB BaseBase
Under this method, the exact
dollar value of a particular
risk management policy can
be easily calculated
(5)
16. 12 Strategic Capital Advisory
Quantifying the Value of Risk Management
January2008
Example 4 – Tying it All Together
Satisfied with the Treasurer’s recommendation, the CFO asks her help in
preparing a presentation to the Board of Directors. To help visualize the possible
policies and see the optimal policy, the Treasurer draws equipreference lines on
the efficient frontier diagram.
Figure 8— Using the New Approach to Find Optimal Strategy
1.00
1.05
1.10
1.15
1.20
0.10 0.12 0.14 0.16 0.18 0.20
ExpectedEPS($)
EPS Risk ($)
Optimal
Strategy
The optimal strategy is then where the lowest equipreference line touches the
efficient frontier.
Drawbacks of the New Approach
The new risk measure we propose meets most of our criteria for the ideal
measure. However, it is not fully universal. It cannot be applied to sub-units in
isolation. The user must always consider the impact of the policy on the overall
earnings and balance sheet of the firm, which requires an estimate of the
correlation of the risk under consideration and the broader risks of the firm.
Nevertheless, the measure can be used in the examination of any policy and
relate to both financial and operational risk.
17. Strategic Capital Advisory 13
Quantifying the Value of Risk Management
January2008
Conclusion
Most existing measures have significant practical and theoretical drawbacks. We
believe that the market-based risk-return trade-off we propose will provide
CFOs and Treasurers with a clear, pragmatic and defensible measure of the costs
and benefits of risk management activities.
Figure 9—The New Approach Improves Upon Traditional Methods
Definitive Risk-Aware
Earnings-
Aware
Non-
Arbitrary
Universal
MinimizeRisk
MinimizeVaR
Efficient Frontier
Sharpe Ratio
EPS & CFS
Volatility
½
½
½
½
18. 14 Strategic Capital Advisory
Quantifying the Value of Risk Management
January2008
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19. Strategic Capital Advisory 15
Quantifying the Value of Risk Management
January2008
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