How do we measure risk?

Risk in investments and financial markets are inherent in nature due to their price fluctuations. Risk is measured in terms of the volatility of the asset. By volatility is means that there is a constant … Read More

Risk in investments and financial markets are inherent in nature due to their price fluctuations. Risk is measured in terms of the volatility of the asset. By volatility is means that there is a constant fluctuations in the actual yield and the expected yield. The risk is measured by the standard deviation observed from the mean actual yield and the number of observation of the assets’ yields. More is the gap of standard deviation more the asset is deemed to be highly volatile and riskier. Plotting the yields as a time series data can show that which asset is highly volatile, if there are large and frequent troughs and peaks within a small period of time then the asset can be deemed to be a risky.

What are the common measures of risk?

Risk measures are statistical measures that are used to predict the risks and volatility involved in investments. There are five measures of measuring risks. They are alpha, beta, R-squared, standard deviation, and Sharpe ratio. These fie can be used as individual measures or can be clubbed together to find out which investment have more risk.

  • Alpha : the alpha measure is a relative risk measurement in comparison of the market index or a selected benchmark. If the asset has a higher performance than the benchmark then the asset has positive alpha and if it has lower performance then the alpha is negative.
  • Beta: beta is used to measure the volatility of the asset or the system risk of the fund in comparison to the market benchmark. If the beta is one then the asset moves in line with the benchmark. If the beta is less than one it asset is less volatile and if it is greater than one the asset is highly volatile.
  • R-squared: it generally measure the rate of change of the investment or the asset in comparison to the benchmark. It shows the correlation of the asset’s performance and yield in comparison to the benchmark. Value of R-squared close to one represents high correlation and near zero low correlation.
  • Standard Deviation: Standard deviation measures the dispersion of the observations from the mean. It is also a measurement of volatility. It is used to determine how much the yield of the investment is deviating from the mean value.
  • Sharpe Ratio: this measures the performance with the risk factor adjusted. For this the risk investment is included and its return is deducted from the expected rate of return. The index is formed by this adjusted rate of return being divided by the standard deviation of the investment. This index then serves as the indicator of whether the investment is a safe one to make or not.

How is financial risk measured?

Financial risk is related to debt management. A company takes debt to grow its business as it needs investments or cash injections. The company’s financial risk is determined how efficiently it pays off the debts. If the firm does not take any debt it will have no Financial risk. The financial risk is reduced by lessening the debt burden. It can be done via equity financing.

The below methods can be used measure the financial risk:

  • The Mean Variance Framework: this measure utilized the two descriptive statistics of mean of the observations and the standard deviation. It is assumed that the observations follow a normal distribution. Investor will look for reducing the downward risk and hence the are more concerned about the values that lie to the left of the mean value of the distribution. Then they tend to look for the volatility of the asset by looking at the standard deviation. The mean value of the observation is its expected value yield value that the investor have taken into consideration. The expected value is calculated based on the probabilities if those observations. (Expected value is the summation of the product of the observation with their respective probabilities).
  • Efficient portfolio frontier is a set of optimal portfolios that gives the highest expected return for a given level of risk or against the lowest risk. This is better explained via a graph. In the graph for every point there exists at least one portfolio, for a given level of expected risk and return. Portfolios outside the efficient frontier are suboptimal in nature. Portfolios lying above the efficient line have higher risks and those lying below have lower return.

Why is measurement of risk important?

Risk measurement becomes important because of the following reasons:

  • Risk is necessary to be quantified to know its magnitude. Hence measurement procedures are required for quantification.
  • When risk are measured it will automatically be understood which assets are worth spending money or which investments are worth the expected return.
  • Risks measurements are required to calculate the level of success and failures tha a organization can take in order to grow. It also is important to know the efficiency of those assets or the shares in bring financial support to the organization.
  • A rational human being or a group of rational human being running a organization needs to measure the risks that they have taken in order to find out future set on actions. As past experiences in investments and assets are important for the individual in his overall success to have a better wealth building process.

Is range a measure of risk?

Range is indeed a measure of risk. It is the preliminary measure used to differentiate between a good performing asset and a bad one. A big range will reveal that the asset is very volatile in nature. While a low range suggests that the fluctuations are not much.

How do you calculate total risk?

The Total Risk is the summation of the Systematic Risk and Diversifiable Risk. The systematic risk is the risk that have impacts on all the investment or classes of investment. Among them inflation is the highest risk as it reduces the real return on the investment.

While the diversifiable risk affects specific firms due to bad or poor management, labour troubles and lawsuits.

This risk can be reduced by investing in other stocks and bonds.

Clara Smith is a guest lecturer for a notable college in the US. Clara has earned her MCA in marketing from Glasgow University. She’s involved with several philanthropic organizations that work on children’s education. She has also been part of and offers dissertation help from students.

Author: EricJones