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Statistical

Measures for Risk


Standard Deviation
1) A measure of the dispersion of a set of data
from its mean. The more spread apart the data,
the higher the deviation. Standard deviation is
calculated as the square root of variance. 

2) In finance, standard deviation is applied to


the annual rate of return of an investment to
measure the investment's volatility. Standard
deviation is also known as historical volatility
and is used by investors as a gauge for the
amount of expected volatility.
  Eg. A volatile stock will have a high standard deviation
while the deviation of a stable blue chip stock will be
lower. A large dispersion tells us how much the return
on the fund is deviating from the expected normal
returns.
Standard Deviation Formula for Portfolio Returns

s = Standard Deviation
rk = Specific Return
rexpected = Expected Return
n = Number of Returns (sample size).
Correlation
A measure that determines the degree to
which two variable's movements are
associated.

The correlation coefficient is calculated as:

The correlation coefficient will vary from -1 to


+1. A -1 indicates perfect negative correlation,
and +1 indicates perfect positive correlation
Covariance
 A measure of the degree to which returns on two risky assets
move in tandem.
 A positive covariance means that asset returns move
together.
 A negative covariance means returns move inversely.
 One method of calculating covariance is by looking at return
surprises (deviations from expected return) in each scenario.
Another method is to multiply the correlation between the
two variables by the standard deviation of each variable.
 Possessing financial assets that provide returns and have a
high covariance with each other will not provide very much
diversification.
 For example, if stock A's return is high whenever stock
B's return is high and the same can be said for low returns,
then these stocks are said to have a positive covariance. If an
investor wants a portfolio whose assets have diversified
earnings, he or she should pick financial assets that have low
What does required rate of
return(RRR) mean?
The rate of return needed to induce investors
or companies to invest in something.

Example- For example, if you invest in a stock,


your required return might be 10% per year.
Your reasoning is that if you don't receive 10%
return, then you'd be better off paying down
your outstanding mortgage, on which you are
paying 10% interest.
Determinants of
Required Returns
Three Components of Required Return:
The time value of money during the time
period
The expected rate of inflation during the period
The risk involved
Complications of Estimating Required Return
A wide range of rates is available for
alternative investments at any time.
The rates of return on specific assets change
dramatically over time.
The difference between the rates available on
different assets change over time.

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Determinants of
Required Returns
The Real Risk Free Rate (RRFR)
Assumes no inflation.
Assumes no uncertainty about future cash
flows.
Influenced by time preference for consumption
of income and investment opportunities in the
economy
Nominal Risk-Free Rate (NRFR)
Conditions in the capital market
Expected rate of inflation

NRFR=(1+RRFR) x (1+ Rate of Inflation) - 1


RRFR=[(1+NRFR) / (1+ Rate of Inflation)] - 1
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Determinants of
Required
Business Risk
Returns
Uncertainty of income flows caused by the
nature of a firm’s business
Sales volatility and operating leverage
determine the level of business risk.
Financial Risk
Uncertainty caused by the use of debt
financing.
Borrowing requires fixed payments which must
be paid ahead of payments to stockholders.
The use of debt increases uncertainty of
stockholder income and causes an increase in
the stock’s risk premium.
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Determinants of
Required
Liquidity Risk
Returns
How long will it take to convert an investment
into cash?
How certain is the price that will be received?
Exchange Rate Risk
Uncertainty of return is introduced by acquiring
securities denominated in a currency different
from that of the investor.
Changes in exchange rates affect the investors
return when converting an investment back into
the “home” currency.

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Determinants of
Required
Country Risk
Returns
Political risk is the uncertainty of returns caused
by the possibility of a major change in the
political or economic environment in a country.
Individuals who invest in countries that have
unstable political-economic systems must
include a country risk-premium when
determining their required rate of return.

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Determinants of
Required Returns
Risk Premium and Portfolio Theory
From a portfolio theory perspective, the
relevant risk measure for an individual asset is
its co-movement with the market portfolio.
Systematic risk relates the variance of the
investment to the variance of the market.
Beta measures this systematic risk of an asset.
According to the portfolio theory, the risk
premium depends on the systematic risk.

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Determinants of
Required Returns
Fundamental Risk versus Systematic Risk
Fundamental risk comprises business risk,
financial risk, liquidity risk, exchange rate risk,
and country risk.
Risk Premium= f ( Business Risk, Financial Risk,
Liquidity Risk, Exchange Rate Risk,
Country Risk)
Systematic risk refers to the portion of an
individual asset’s total variance attributable to
the variability of the total market portfolio.
Risk Premium= f (Systematic Market Risk)

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What does risk free return
mean?
The theoretical rate of return attributed to an
investment with zero risk. The risk-free rate
represents the interest on an investor's money that
he or she would expect from an absolutely risk-free
investment over a specified period of time.
In theory, the risk-free rate is the minimum return
an investor should expect for any investment, as
any amount of risk would not be tolerated unless
the expected rate of return was greater than the
risk-free rate.
In practice, however, the risk-free rate does not
technically exist; even the safest investments carry
a very small amount of risk. Thus, investors
commonly use the interest rate on a three-month
U.S. Treasury bill as a proxy for the risk-free rate
because short-term government-issued securities
What does risk premium
mean?
 The return in excess of the risk-free rate of return that
an investment is expected to yield. An asset's risk
premium is a form of compensation for investors who
tolerate the extra risk - compared to that of a risk-free
asset - in a given investment.
Think of a risk premium as a form of hazard pay for your
investments. Just as employees who work relatively
dangerous jobs receive hazard pay as compensation for
the risks they undertake, risky investments must
provide an investor with the potential for larger returns
to warrant the risks of the investment.

For example, high-quality corporate bonds issued by


established corporations earning large profits have very
little risk of default. Therefore, such bonds will pay a
lower interest rate (or yield) than bonds issued by less-
established companies with uncertain profitability and
relatively higher default risk.
3 types of Risk Premium
a) Equity risk premium- Difference between the
return on equity stocks as a class and the risk-
free rate represented by the return on treasury
Bill.
b) Bond Horizon Premium- Difference between
the return on long-term government bonds and
the return on treasury Bill.
c) Bond Default Premium- Difference between
the return on long-term corporate bonds and
the return on long-term government bonds.

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