Risk

 

When looking at the potential return on an investment, you should also look at the risk and the liquidity.

 

Risk Definitions

 

An asset might have a real rate of return which is different than was expected. People saving money do not like risk and are hesitant to hold assets with a high degree of uncertainty in their return. Fluctuating returns are seen as high volatility and reduce the savers desire to hold the asset.

 

 

In finance, risk is the probability that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment. It is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment.

 

Table of Contents

Risk Risk Definitions Measuring Risk Risk-free rate Solency Risk CDS to measure risk: Altman's Z-Score The Interpretation of Z Score: More links

 

 

 

 

 

see rise in risk aversion

 

Measuring Risk

 

To measure the risk of a portfolio of investments, you need to see how closely the expected return is clustered around the average return. The spread, or dispersion, of the returns over time will tell you how likely that the future return will be as expected. The two most common tools for measuring dispersion risk are standard deviation and variance.

 

Measure volatility is because it is a great measure of risk.  The higher the volatility, the higher the standard deviation of expected returns.  Because returns are less certain, the level of risk is higher.

 

On the other hand, investments in options becomes more valuable as volatility rises. Why?  because there is a greater chance that (due to the higher volatility), you might be "in the money".  See our discussion on Options for more details..

 

 

 

Risk-free rate

 

see T-bills for the US risk-free rate

 

 

Solency Risk

 

Measuring the 'Fiscal-Fitness' of a company: The Altman Z-Score

In the early 60's Edward Altman, using Multiple Discriminant Analysis combined a set of 5 financial ratios to come up with the Altman Z-Score. This score uses statistical techniques to predict a company's probability of failure using the following 8 variables from a company's financial statements:

 

http://www.creditguru.com/CalcAltZ.shtml

go here for a neat calculator

 

CDS to measure risk:

 

Question:  what is a better measure of risk....spreads over German bund? or, sovereign credit default swaps (to measure default risk_? can they be different? where can you go to find this data?

 

Answer (thank you Aaron!):   There are several types of risks. The best measure of CREDIT risk is found in credit default swap spreads. This would be your best indicator of DEFAULT risk because a CDS only prices in the chance of a credit event occurring. If you think Spain has a better chance of defaulting than Germany, like I do, you would expect the CDS trading on Spain to be greater than Germany. It is, 5-year Spanish CDS is 141 bps while 5-year German CDS is 57.5 bps, a difference of 83.5 basis points. This means it costs $8,350/year more to insure $1 million of Spanish debt vs German debt.

 

The difference in CREDIT risk has to show up in the current yields or there would be an arbitrage opportunity. Generic Spanish 5-year debt is trading 106 basis points above German debt. The extra 22.5 basis points probably are due to LIQUIDITY risks, German bunds are more liquid and therefore get a liquidity premium; and maybe more importantly, FINANCING risk. For a leverage player it probably costs more (reflected in a repo rate) to borrow against Spanish debt than German debt. Or borrowing against Spanish debt uses more capital (reflected in larger haircuts).

 

For DEFAULT risk use CDS. 

 

more: Credit Default Swap (CDS) market

 

 

 

 

 

 

Altman's Z-Score

 

The 5 financial ratios in the Altman Z-Score and their respective weight factor is as follows:

	RATIO	WEIGHTAGE
A	EBIT/Total Assets	x. 3.3	-4 to +8.0
B	Net Sales /Total Assets	x 0.999	-4 to +8.0
C	Market Value of Equity / Total Liabilities	x 0.6	-4 to +8.0
D	Working Capital/Total Assets	x 1.2	-4 to +8.0
E	Retained Earnings /Total Assets	x1.4	-4 to +8.0

 

 

These ratios are multiplied by the weightage as above, and the results are added together.

Z-Score = A x 3.3 + B x 0.99 + C x 0.6 + D x 1.2 + E x 1.4

 

 

The Interpretation of Z Score:

Z-SCORE ABOVE 3.0 -The company is safe based on these financial figures only.

Z-SCORE BETWEEN 2.7 and 2.99 - On Alert. This zone is an area where one should exercise caution.

Z-SCORE BETWEEN 1.8 and 2.7 - Good chances of the company going bankrupt within 2 years of operations from the date of financial figures given.

Z-SCORE BELOW 1.80- Probability of Financial embarassment is very high.

 

 

 

 

Explanation of Altman's Z-Score:

Altman's Z-Score formula weighs five ratios then adds them together to come up with a bankruptcy prediction estimate for a company.  This estimate of bankruptcy for publicly-held companies depends on the resulting score of Altman's Z-Score formula, which the score is divided into four categories:

 

Less than 1.8:	Bankruptcy risk is high
Between 1.8 and 2.7:	Bankruptcy risk is fair
Between 2.7 and 3.0:	Bankruptcy risk is possible, but not likely in the near-future
Higher than 3.0:	Bankruptcy risk is low

 

 

Importance of Altman's Z-Score:

A score greater than 3.0, or an increasing Altman's Z-Score is usually a positive sign.  The higher the score, the better the company's chances of avoiding bankruptcy, but this score should be checked against other companies and industry standards. It should be noted that large economic events, like an entire industry slowdown, would render this scoring method less accurate.  The individual components of this formula should be monitored, as they are the key to understanding how the score was calculated.

 

 

 

 

 

 

 

More links

 

see also:

risk-premium

return

T-bills

Finance