1 RETURNS AND RISK

Review: Return and Risk

 Financial assets are generally described by their risk and return
characteristics
 Financial assets normally generate two types of return for
investor: periodic income (dividends or interest payments) and
price change (capital gain/loss)
 Gross and net return
 A gross return is the return earned by an asset manager prior to deductions
for management expenses, custodial fees, taxes, or any other expenses
that are not directly related to the generation of returns but rather related
to the management and administration of an investment
 Net return is a measure of what the investment vehicle has earned for the
investor. Net return deducts all managerial and administrative expenses
that reduce an investor’s return
 Pre-tax and after-tax nominal return
 Real return 2
Holding Period Returns
 Suppose you invest in a stock index fund. The fund
currently sells for $100 per share. Suppose your
investment horizon is one year. If the price per share at
year’s end $110 and the cash dividends over the year are
$5, what is your holding period return?

P1  P0 D1
r 
P0 P0

Multi-Period Returns

r  1  r1 1  r2  1  rn   1

 What was your average annual return over the five-

year period?
 Annualising returns?

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LAB: Basics of Return

 Use the file: lab_101_Prices to Returns.ipynb

 Data file: sample_prices.csv

Notes: These files are provided by EDHEC

Business School

Risk
 Risk is defined as the uncertainty over the amount or timing of
future cash flows from an investment, or the variability of returns
from those that are expected
 The risk of a security can be considered in isolation, or on a
portfolio basis; this distinction is critical for portfolio theory
 Some investments are risk free, e.g., a default free T-bond.
 Most investments, however, are risky. Consider an investment in a
stock, which offers a return in the form of a dividend and capital
gain; the return that the investor receives is risky, since both the
dividend and the future sale price of the stock is uncertain
 Other risky investments include government bonds to be sold
before maturity, corporate bonds, derivatives, commodities, real
estate, a firm’s physical assets, human capital
 The most common risk measure is the standard deviation 6
Measuring risk
 Variance is the expected value of squared deviations
from the mean.
 Standard deviation is the square root of variance.
 The higher the variability or the volatility of the
outcomes is, the higher will be the squared
deviations.
 Variance and standard deviation provide one measure
of uncertainty – or the risk – in outcomes.

Measuring risk

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LAB: Volatility and Risk

 Use the file: lab_102_Volatility and Risk.ipynb

 Data files:
 ind30_m_vw_rets.csv

Alternative measures of risk

 There are alternative ways to measure risk, for
example:
 Range of returns
 Semi-variance: a measure that only considers
deviations below the mean
 Maximum drawdown: the return from the highest
price to the lowest price over a period of time (this
measure is widely used by traders)

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Semi Variance and Semi-Deviation

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Maximum Drawdown

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Maximum Drawdown
Step 1: Computing a drawdown is to construct a wealth
index (hypothetical buy-and-hold investment in the asset)

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Maximum Drawdown
Step 2: Look at the prior peak at any point in time

Step 3: Compute the Drawdown as the difference between

the previous peak and the current value 14
Maximum Drawdown

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Maximum Drawdown

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LAB: Drawdown

 Use the file: lab_103_Maximum Drawdown.ipynb

 Data files:
 Portfolios_Formed_on_ME_monthly_EW.csv

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LAB: Building a Module

 Use the file: lab_104_Building a Module.ipynb

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LAB: Deviations from Normality (Self – Study)

 Use the file:

lab_105_ Deviations from Normality.ipynb

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Value at Risk
 Value at risk is the minimum loss that would be
expected a certain percentage of the time over a certain
period of time given the assumed market conditions.
 The following three points are important in
understanding the concept of VaR:
 VaR can be measured in either currency units or in
percentage terms.
 VaR is a minimum loss. This point cannot be emphasized
enough. VaR is often mistakenly assumed to represent how
much one can lose.
 A VaR statement references a time horizon
The 5% VaR of a portfolio is €2.2 million over
a one-day period 20
Value at Risk
The 5% VaR of a portfolio is €2.2 million over
a one-day period
Using the example given, it is correct to say any of the
following:
 €2.2 million is the minimum loss we would expect 5%
of the time.
 5% of the time, losses would be at least €2.2 million.
 We would expect a loss of no more than €2.2 million
95% of the time.

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Value at Risk

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Estimating VaR
 Historical Approach

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Estimating VaR
 Variance – Covariance Approach

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Estimating VaR
 Variance – Covariance Approach

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Estimating VaR
 Monte Carlo Simulation:
Monte Carlo simulation is a method of estimating VaR
in which the user develops his own assumptions about
the statistical characteristics of the distribution and uses
those characteristics to generate random outcomes that
represent hypothetical returns to a portfolio with the
specified characteristics

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Advantages of VaR
 Simple concept: VaR is relatively easy to
understand.
 Easily communicated concept.
 Provides a basis for risk comparison
 Facilitates capital allocation decisions.
 Can be used for performance evaluation.
 Reliability can be verified.
 Widely accepted by regulators.

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Limitations of VaR
 Subjectivity
 Underestimating the frequency of extreme
events
 Failure to take into account liquidity
 Sensitivity to correlation risk.
 Vulnerability to trending or volatility regimes
 Misunderstanding the meaning of VaR
 Oversimplification.
 Disregard of right-tail events.

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Extensions of VaR
 Conditional Value at Risk (CVaR) attempts to address
the shortcomings of the VaR. CVaR is the expected loss
if that worst-case threshold is ever crossed. CVaR, in
other words, quantifies the expected losses that occur
beyond the VaR breakpoint.
 Beyond assessing tail loss, a risk manager often wants to
know how the portfolio VaR will change if a position
size is changed relative to the remaining positions. This
effect can be captured by a concept called incremental
VaR (IVaR)

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Extensions of VaR
 A related concept is called marginal VaR (MVaR). It is
conceptually similar to incremental VaR in that it reflects
the effect of an anticipated change in the portfolio, but it
uses formulas derived from calculus to reflect the effect
of a very small change in the position. Some people
interpret MVaR as a change in the VaR for a $1 or 1%
change in the position, although that is not strictly
correct. Nonetheless, this interpretation is a reasonable
approximation of the concept behind marginal VaR,
which is to reflect the impact of a small change

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LAB: Estimating VaR

 Use the file: lab_106_Downside Measures.ipynb

 Data files:
 edhec-hedgefundindices.csv

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Other key risk measures

 Sensitivity Risk Measures:
 Equity Exposure Measures: Beta
 Fixed-Income Exposure Measures: Duration
and Convexity
 Options Risk Measures: Delta, Gamma, Vega
 Scenario Risk Measures
 Historical Scenarios
 Hypothetical Scenarios

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