RISK-RETURN MEASURES

Asset Pricing and Portfolio Choice

Universit degli Studi di Torino April 2012

Giulio Casuccio
Head of Quantitative Strategies and Research giulio.casuccio@fondacosgr.it

Risk-Return Trade Off

Risk aversion is a common factor among all different types of in investors, so higher uncertainty and volatility should be rewarded with higher expected return. Risk taking is the main driver of return so any financial performance should be always evaluated taking into account risk and return jointly. Correctly measuring risk is not obvious and doing it in the proper way is crucial in evaluating and choosing investments.
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Coherent Measure of Risk (1)

A coherent measure of risk R is defined by satisfying four main axioms:

Monotonicity the larger the loss, the larger the the risk. If X < Y then R(X) < R(Y)
Positive Homogeneity If the loss is multiplied by a positive factor, risk should increase by the same factor. If n > 0 then R(nX) > R(X)
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Risk-Return Measures

Coherent Measure of Risk (2)

Translational Invariance Risk free position decrease the risk. R(X + a) = R(X) a where a is a risk free position

Sub-Additivity The risk of aggregated is less than or equal to sum of the individual risk (diversification benefit). R(X + Y) < R(X) + R(Y)
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Measure of Risk: classification (1)

Measures of risk should be classified across different dimensions, depending on their characteristics and objectives: Scale Independent They do not consider the risk aversion degree of the investor. Or Utility Based Risk is corrected by the investor s degree of risk aversion, which should be specified, but it is not unique for all investors.
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Measure of Risk: classification (2)

Absolute Risk Measure Risk is calculated without considering any market index or benchmark as reference. Or

Relative Risk Measure Risk is defined with respect to a specific market index or benchmark, consistent with the characteristics of the investment, or a cash equivalent risk free position.
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Measure of Risk: classification (3)

Symmetric Risk Measure Risk is defined as the volatility with respect to a certain value, calculated or expected, not distinguishing between higher or lower results. Or Asymmetric Risk Measure Exclusively returns below a certain value, calculated or expected, are taking into account: only negative events are considered as risk.
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Measure of Risk: classification (4)

Ex Post Risk Measure They calculate the realized risk and return over a specific period, which represents simply one of the different possible scenarios. Or Ex Ante Risk Measure They aim to shape the whole distribution of expected returns, empirical or theoretical, and to quantify the probability of specific well defined events.
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Symmetric Risk Measure: Standard Deviation

The standard deviation (volatility) is a measure of the dispersion of a collection on returns defined as the root-mean-square (RMS) on the values from their mean.
It is expressed in the same unit of the data and it implies normal (symmetrical) distribution of returns (central limit theorem and 68-95-99.7 rule). It is the most common measure of risk but not the most appropiate: it violates monotonocity axiom.
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Symmetric Risk Measure: Sharpe Ratio (1)

The Sharpe ratio (reward to volatility ratio) is a measure of the excess return with respect to the risk free rate per unit risk.

It is always calculated ex-post over a specific time period and assuming a constant risk free rate. It implies any investor to select the investment instrument with the higher Sharpe ratio, independently from his risk aversion.
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Symmetric Risk Measure: Sharpe Ratio (2)

Sharpe ratio assumes zero investment strategy: each level of volatility is efficiently obtained through the combination of risk free asset with the investment which offers the highest Sharpe ratio.
Risk free Investment 1 Investment 2 Investor Risk-Aversion: Exp. Return 3,00% 5,00% 8,00% Vol. < 10% Exp. Return Strategy 1 100% Investment 1: Startegy 2 50% Investment 2 + 50% Risk Free 5,00% Volatility 10,00% Sharpe Ratio 0,20 Volatility 0,00% 10,00% 20,00% Sharpe Ratio 0,20 0,25

5,50%

10,00%

0,25

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Asymmetric Risk Measure: Downside Volatility

The downside volatlity is a measure of the dispersion of the negative realizations of a collection on returns. It is defined as the root-mean-square (RMS) of the negative values from their mean, assuming the positive ones equal zero.

Only the probability of a negative return is considered as risk.

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Asymmetric Risk Measure: Maximum Drawdown (1)

The Maximum Drawdown is calculated starting from the cumulative returns series. Drawdown is defined as the difference between any local maximum and its relative minimum and the Maximum Drawdown is the largest drawdown found over the considered period.

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Asymmetric Risk Measure: Maximum Drawdown (2)

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Asymmetric Risk Measure: Stirling Ratio

MDD is commonly used as measure of risk for commodity investments and hedge funds through the widespread utilization of different indices. Stirling Ratio measures the profit divided by the maximum drawdown over a specified period. It is calculated as the ratio between the rate of return (or the excess return) and the MDD. It can be considered as a modification of the Sharpe ratio where the denominator is replaced by the MDD.
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Relative Risk Measure: Tracking Error (1)

Tracking Error is a measure of how closely a portfolio follows the market or its benchmark. It is defined as the standard deviation of the difference between the portfolio returns and the market index or benchmark returns.

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Relative Risk Measure: Tracking Error (2)

Tracking Error is a useful measure to distinguish between passive, enhanced passive and active portfolios. The former would have a TE close to zero, ideally lower than 2%, while the latter have a higher TE, usually within 5%. Too large tracking errors can be due to a misspecified benchmark or to an incoherent management style.
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Relative Risk Measure: Information Ratio

Information Ratio measures the active return of a portfolio divided by the amount of risk the manager takes relative to a benchmark. It is defined as the ratio between the excess return with respect to a defined benchmark and the realized tracking error. The ratio shows the risk-adjusted active return measuring the excess return obtained for each unit of active risk taken so it directly evaluates the managers ability.
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Relative Risk Measure: Jensens Alpha

Jensens Alpha is used to determine the excess return of a portfolio over its theoretical expected return. The theoretical return is predicted by a market model, most commonly the CAPM, measuring the sensitivity of the portfolio to the market by its market beta.
Jensen's alpha = Portfolio Ret. - (Risk Free Rate + Portfolio Beta * (Market Ret. - Risk Free Rate))
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Ex Ante Risk Measure: Shortfall Probability

Given the expected return distribution of a portofolio, Shortfall Probability measures the weight of the negative estimated values. So it indicates the ex ante probablity of realized returns lower than zero or lower than a reference index return. Obviously how to calculate Shortfall Probability and the accuracy of the result depends on the quality of the estimation of the expected returns and so it is not unique.
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Ex Ante Risk Measure: Value at Risk (1)

Given the expected returns distribution of a portfolio, Value at Risk is calculated with respect to a specified probability and time horizon. VaR measures the maximum expected loss within the confidence level defined by the specified probability and time horizon. For example, a 5% VaR at 1 month equal to 2% means that the expected loss in one month is lower than 2% with a probability of 95%.
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Ex Ante Risk Measure: Value at Risk (2)

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Ex Ante Risk Measure: Value at Risk (3)

Given some confidence level (0,1) the VaR of the portfolio at the confidence level is given by the smallest number l such that the probability that loss L exceedes l is not larger than (1 ).

VaR definition assumes no trades during the specified time horizon and normal distribution of returns.
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Ex Ante Risk Measure: Value at Risk (4)

Common parameters for VaR are 1%, 5% and 10% and it is usually calculated on different time horizons, from 1 day to 1 year, even if the longer the time horizon the less meaningful the result. The definition of VaR is nonconstructive, it specifies a property it must have but not how to compute the VaR: it depends on the chosen probability distributions of returns. It is not a complete coherent measures of risk because it violates the sub-additivity axiom.
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Ex Ante Risk Measure: Expected Shortfall (1)

Expected Shortfall (ES) is an alternative to VaR and it measures the expected return of a portfolio at each quantile (q) of its returns distribution. ES is computed taking into account the whole distribution (probability density function) up to the specified quantile and not only a single event probability.

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Ex Ante Risk Measure: Expected Shortfall (2)

Probability 10% 30% 40% 20% q 5% 10% 20% 40% 100% Profit/Loss -100 -20 0 50 ES q -100 -100 -60 -40 -6

[5%*(-100)]/5% [10%*(-100)]/10% [10%*(-100)+10%*(-20)]/20% [10%*(-100)+30%*(-20)]/40% [10%*(-100)+30%*(-20)+40%*(0)+20%*(50)]/100%

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Ex Ante Risk Measure: Expected Shortfall (3)

ES evaluates risk in a conservative way by focusing on the less profitable outcomes: for high values of q it ignores the most profitable but unlikely possibilities, for small q it focuses on worst losses. ESq increases as q increases and the 100% ES equals the expected value of the portfolio. For a given portfolio ESq is worse (or equal) than the VaR(q) at the same q level. Expected Shortfall is a coherent risk measure.
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