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 covariance to
each other.
 Required Rate of Return
 The rate of return needed to induce investors
or companies to invest in something.
 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.
Risk Free Rate of Return
 The risk-free rate represents the interest an
investor would expect from an absolutely risk-
free investment over a specified period of time.
 The risk-free rate is the minimum return an
investor expects for any investment because he
or she will not accept additional risk unless the
potential rate of return is greater than the risk-
free rate.
 In practice, however, the risk-free rate does not
exist because even the safest investments carry
a very small amount of risk. Thus, the interest
rate on a three-month U.S. Treasury bill is often
used as the risk-free rate.
Risk Premium
 The additional return investors expect to get,
or investors earned in the past, for assuming
additional risk.
 It may be calculated between 2 classes of
securities that differ in their risk level.
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.
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
Returns
 Business Risk
◦ 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
Returns
 Liquidity Risk
◦ 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
Returns
 Country Risk
◦ 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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