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
 Credit 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
1. Standard deviation,
2. Sharp ratio
3. Beta, value at risk (VaR),
4. Conditional value at risk (CVaR).
5. 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