What is a 'Risk Asset'

A risk asset is any asset that carries a degree of risk. Risk asset generally refers to assets that have a
significant degree of price volatility, such as equities, commodities, high-yield bonds, real estate and
currencies. Specifically in the banking context, risk asset refers to an asset owned by a bank or
financial institution whose value may fluctuate due to changes in interest rates, credit
quality, repayment risk and so on. The term may also refer to equity capital in a financially stretched
or near-bankrupt company, as its shareholders claims would rank below those of the firms
bondholders and other lenders.

BREAKING DOWN 'Risk Asset'

Investor appetite for risk assets swings considerably over time. The period from 2003 to 2007 was
one of huge risk appetite, as rampant investor demand drove up prices of most assets associated
with above-average risk, including commodities, emerging markets, subprime mortgage-backed
securities, as well as currencies of commodity exporters such as Canada and Australia. The global
recession of 2008 to 2009 triggered massive aversion for risk assets, as capital fled to the
quintessential safe-haven of U.S. Treasuries.

Since March 2009, as swings in risk appetite became more pronounced due to global
macroeconomic concerns, such as European sovereign debt (in 2010 and 2011) and the U.S. fiscal
cliff (in 2012), market-watchers began referring to times when investors have substantial appetite for
risk assets as "risk on" periods and intervals of risk aversion as "risk off" periods.

What is 'Financial Risk'

Financial risk is the possibility that shareholders will lose money when they invest in a company that
has debt, if the company's cash flow proves inadequate to meet its financial obligations. When a
company uses debt financing, its creditors are repaid before its shareholders if the company becomes
insolvent. Financial risk also refers to the possibility of a corporation or government defaulting on its
bonds, which would cause those bondholders to lose money

BREAKING DOWN 'Financial Risk'

Financial risk is the general term for many different types of risks related to the finance industry.
These include risks involving financial transactions such us company loans, and its exposure to loan
default. The term is typically used to reflect an investor's uncertainty of collecting returns and the
potential for monetary loss.

Investors can use a number of financial risk ratios to assess an investment's prospects. For example,
the debt-to-capital ratio measures the proportion of debt used, given the total capital structure of the
company. A high proportion of debt indicates a risky investment. Another ratio, the capital expenditure
ratio, divides cash flow from operations by capital expenditures to see how much money a company
will have left to keep the business running after it services its debt.

Types of Financial Risks

There are many types of financial risks. The most common ones include credit risk, liquidity risk,
asset backed risk, foreign investment risk, equity risk and currency risk.
Credit risk is also referred to as default risk. This type of risk is associated with people who borrowed
money and who are unable to pay for the money they borrowed. As such, these people go into
default. Investors affected by credit risk suffer from decreased income and lost principal and interest,
or they deal with a rise in costs for collection.

Liquidity risk involves securities and assets that cannot be purchased or sold fast enough to cut
losses in a volatile market. Asset-backed risk is the risk that asset-backed securities may become
volatile if the underlying securities also change in value. The risks under asset-backed risk include
prepayment risk and interest rate risk.

Changes in prices because of market differences, political changes, natural calamities, diplomatic
changes or economic conflicts may cause volatile foreign investment conditions that may expose
businesses and individuals to foreign investment risk. Equity risk covers the risk involved in the
volatile price changes of shares of stock.

Investors holding foreign currencies are exposed to currency risk because different factors, such as
interest rate changes and monetary policy changes, can alter the value of the asset that investors are
holding.

Financial Risk is one of the major concerns of every business across fields and geographies.
This is the reason behind Financial Risk Manager FRM Exam gaining huge recognition among
financial experts across the globe. FRM is the top most credential offered to risk management
professionals worldwide. Financial Risk again is the base concept of FRM Level 1 exam. Before
understanding the techniques to control risk and perform risk management, it is very important
to realize what risk is and what the types of risks are. Let's discuss different types of risk in this
post.
Risk and Types of Risks:
Risk can be referred as the chances of having an unexpected or negative outcome. Any action
or activity that leads to loss of any type can be termed as risk. There are different types of risks
that a firm might face and needs to overcome. Widely, risks can be classified into three
types: Business Risk, Non-Business Risk and Financial Risk.

1. Business Risk : These types of risks are taken by business enterprises themselves in order to
maximize shareholder value and profits. As for example: Companies undertake high cost risks in
marketing to launch new product in order to gain higher sales.
2. Non- Business Risk : These types of risks are not under the control of firms. Risks that arise
out of political and economic imbalances can be termed as non-business risk.
3. Financial Risk : Financial Risk as the term suggests is the risk that involves financial loss to
firms. Financial risk generally arises due to instability and losses in the financial market caused
by movements in stock prices, currencies, interest rates and more.

Types of Financial Risks:

Financial risk is one of the high-priority risk types for every business. Financial risk is caused
due to market movements and market movements can include host of factors. Based on this,
financial risk can be classified into various types such as Market R isk, Credit Risk, Liquidity
Risk, Operational Risk and Legal Risk.
Market Risk:
This type of risk arises due to movement in prices of financial instrument . Market risk can be
classified as Directional Risk and Non - Directional Risk . Directional risk is caused due to
movement in stock price, interest rates and more. Non- Directional risk on the other hand can
be volatility risks.
Credit Risk:
This type of risk arises when one fails to fulfill their obligations towards their counter
parties. Credit risk can be classified into Sovereign Risk and Settlement Risk . Sovereign risk
usually arises due to difficult foreign exchange policies. Settlement risk on the other hand arises
when one party makes the payment while the other party fails to fulfill the obligations.
Liquidity Risk:
This type of risk arises out of inability to execute transactions. Liquidity risk can be classified
into Asset Liquidity Risk and Funding Liquidity Risk . Asset Liquidity risk arises either due
to insufficient buyers or insufficient sellers against sell ord ers and buy orders respectively.
Operational Risk:
This type of risk arises out of operational failures such as mismanagement or technical failures.
Operational risk can be classified into Fraud Risk and Model Risk . Fraud risk arises due to
lack of controls and Model risk arises due to incorrect model application.
Legal Risk:
This type of financial risk arises out of legal constraints such as lawsuits. Whenever a company
needs to face financial loses out of legal proceedings, it is legal risk.

What is the 'Capital Asset Pricing Model - CAPM'

The capital asset pricing model (CAPM) is a model that describes the relationship between
systematic risk and expected return for assets, particularly stocks. CAPM is widely used
throughout finance for the pricing of risky securities, generating expected returns for assets
given the risk of those assets and calculating costs of capital.

BREAKING DOWN 'Capital Asset Pricing Model - CAPM'

The formula for calculating the expected return of an asset given its risk is as follows:

The general idea behind CAPM is that investors need to be compensated in two ways: time value of
money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and
compensates the investors for placing money in any investment over a period of time. The risk-free
rate is customarily the yield on government bonds like U.S. Treasuries.

The other half of the CAPM formula represents risk and calculates the amount of compensation the
investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that
compares the returns of the asset to the market over a period of time and to the market premium
(Rm-rf): the return of the market in excess of the risk-free rate. Beta reflects how risky an asset is
compared to overall market risk and is a function of the volatility of the asset and the market as well
as the correlation between the two. For stocks, the market is usually represented as the S&P 500 but
can be represented by more robust indexes as well.

The CAPM model says that the expected return of a security or a portfolio equals the rate on a risk-
free security plus a risk premium. If this expected return does not meet or beat the required return,
then the investment should not be undertaken. The security market line plots the results of the CAPM
for all different risks (betas).

Example of CAPM
Using the CAPM model and the following assumptions, we can compute the expected return for a
stock:

The risk-free rate is 2% and the beta (risk measure) of a stock is 2. The expected market return over
the period is 10%, so that means that the market risk premium is 8% (10% - 2%) after subtracting the
risk-free rate from the expected market return. Plugging in the preceding values into the CAPM
formula above, we get an expected return of 18% for the stock:

18% = 2% + 2 x (10%-2%)

Market Risk Premium

The market risk premium is the difference between the expected return on a market portfolio and the
risk-free rate. Market risk premium is equal to the slope of the security market line (SML), a graphical
representation of the capital asset pricing model (CAPM). CAPM measures required rate of return on
equity investments, and it is an important element of modern portfolio theory and discounted cash
flow valuation.

Market risk premium describes the relationship between returns from an equity market portfolio
and treasury bond yields. The risk premium reflects required returns, historical returns and expected
returns. The historical market risk premium will be the same for all investors since the value is based
on what actually happened. The required and expected market premiums, however, will differ from
investor to investor based on risk tolerance and investing styles.

Theory
Investors require compensation for risk and opportunity cost. The risk-free rate is a theoretical interest
rate that would be paid by an investment with zero risk, and long-term yields on U.S. treasuries have
traditionally been used as a proxy for the risk-free rate because of the low default risk. Treasuries
have historically had relatively low yields as a result of this assumed reliability. Equity market returns
are based on expected returns on a broad benchmark index such as the Standard & Poor's 500 index
of the Dow Jones Industrial Average. Real equity returns fluctuate with operational performance of
the underlying business, and the market pricing for these securities reflects this fact. Historical return
rates have fluctuated as the economy matures and endures cycles, but conventional knowledge has
generally estimated long-term potential of approximately 8% annually. As of 2016, some economists
are calling for a reduction in this assumed rate, though opinions on the topic diverge. Investors
demand a premium on their equity investment return relative to lower risk alternatives because their
capital is more jeopardized, which leads to the equity risk premium.

Calculation and Application

The market risk premium can be calculated by subtracting the risk-free rate from the expected equity
market return, providing a quantitative measure of the extra return demanded by market participants
for increased risk. Once calculated, the equity risk premium can be used in important calculations
such as CAPM. Between 1926 and 2014, the S&P 500 exhibited a 10.5% compounding annual rate
of return, while the 30-day treasury bill compounded at 5.1%. This indicates a market risk premium of
5.4%, based on these parameters.

The required rate of return for an individual asset can be calculated by multiplying the asset's beta coefficient
by the market coefficient, then adding back the risk-free rate. This is often used as the discount rate in
discounted cash flow, a popular valuation model.

The Capital Asset Pricing Model: an Overview

No matter how much we diversify our investments, it's impossible to get rid of all the risk. As investors, we
deserve a rate of return that compensates us for taking on risk. The capital asset pricing model (CAPM) helps
us to calculate investment risk and what return on investment we should expect. Here we take a closer look at
how it works.

Birth of a Model
The capital asset pricing model was the work of financial economist (and later, Nobel laureate in
economics) William Sharpe, set out in his 1970 book "Portfolio Theory and Capital Markets." His
model starts with the idea that individual investment contains two types of risk:

1. Systematic Risk These are market risks that cannot be diversified away. Interest
rates, recessions and wars are examples of systematic risks.
 2. Unsystematic Risk Also known as "specific risk," this risk is specific to individual stocks and can be
diversified away as the investor increases the number of stocks in his or her portfolio. In more technical
terms, it represents the component of a stock's return that is not correlated with general market moves.

Modern portfolio theory shows that specific risk can be removed through diversification. The trouble is
that diversification still doesn't solve the problem of systematic risk; even a portfolio of all the shares
in the stock market can't eliminate that risk. Therefore, when calculating a deserved return,
systematic risk is what plagues investors most. CAPM, therefore, evolved as a way to measure this
systematic risk.

The Formula
Sharpe found that the return on an individual stock, or a portfolio of stocks, should equal its cost of
capital. The standard formula remains the CAPM, which describes the relationship between risk
and expected return.

Here is the formula:

CAPM's starting point is the risk-free rate typically a 10-year government bond yield. To this is
added a premium that equity investors demand to compensate them for the extra risk they accept.
This equity market premium consists of the expected return from the market as a whole less the risk-
free rate of return. The equity risk premium is multiplied by a coefficient that Sharpe called "beta."

Beta
According to CAPM, beta is the only relevant measure of a stock's risk. It measures a stock's
relative volatility that is, it shows how much the price of a particular stock jumps up and down
compared with how much the stock market as a whole jumps up and down. If a share price moves
exactly in line with the market, then the stock's beta is 1. A stock with a beta of 1.5 would rise by 15%
if the market rose by 10% and fall by 15% if the market fell by 10%.

Beta is found by statistical analysis of individual, daily share price returns, in comparison with the
market's daily returns over precisely the same period. In their classic 1972 study "The Capital Asset
Pricing Model: Some Empirical Tests," financial economists Fischer Black, Michael C. Jensen and
Myron Scholes confirmed a linear relationship between the financial returns of stock portfolios and
their betas. They studied the price movements of the stocks on the New York Stock
Exchange between 1931 and 1965.
Beta, compared with the equity risk premium, shows the amount of compensation equity investors
need for taking on additional risk. If the stock's beta is 2.0, the risk-free rate is 3%, and the market
rate of return is 7%, the market's excess return is 4% (7% - 3%). Accordingly, the stock's excess
return is 8% (2 X 4%, multiplying market return by the beta), and the stock's total required return is
11% (8% + 3%, the stock's excess return plus the risk-free rate).

What this shows is that a riskier investment should earn a premium over the risk-free rate the
amount over the risk-free rate is calculated by the equity market premium multiplied by its beta. In
other words, it's possible, by knowing the individual parts of the CAPM, to gauge whether or not
the current price of a stock is consistent with its likely return that is, whether or not the investment is
a bargain or too expensive.

What CAPM Means for You

This model presents a very simple theory that delivers a simple result. The theory says that the only
reason an investor should earn more, on average, by investing in one stock rather than another is
that one stock is riskier. Not surprisingly, the model has come to dominate modern financial theory.
But does it really work?

It's not entirely clear. The big sticking point is beta. When professors Eugene Fama and Kenneth
French looked at share returns on the New York Stock Exchange, the American Stock
Exchange and Nasdaq between 1963 and 1990, they found that differences in betas over that lengthy
period did not explain the performance of different stocks. The linear relationship between beta and
individual stock returns also breaks down over shorter periods of time. These findings seem to
suggest that CAPM may be wrong.
While some studies raise doubts about CAPM's validity, the model is still widely used in the
investment community. Although it is difficult to predict from beta how individual stocks might react to
particular movements, investors can probably safely deduce that a portfolio of high-beta stocks will
move more than the market in either direction, and a portfolio of low-beta stocks will move less than
the market.

This is important for investors especially fund managers because they may be unwilling to or
prevented from holding cash if they feel that the market is likely to fall. If so, they can hold low-beta
stocks instead. Investors can tailor a portfolio to their specific risk-return requirements, aiming to hold
securities with betas in excess of 1 while the market is rising, and securities with betas of less than 1
when the market is falling.

Not surprisingly, CAPM contributed to the rise in use of indexing assembling a portfolio of shares to
mimic a particular market by risk-averse investors. This is largely due to CAPM's message that it is
only possible to earn higher returns than those of the market as a whole by taking on higher risk
(beta).

The Bottom Line

The capital asset pricing model is by no means a perfect theory. But the spirit of CAPM is correct. It
provides a usable measure of risk that helps investors determine what return they deserve for putting
their money at risk.

Arbitrage Pricing Theory APT

What is the 'Arbitrage Pricing Theory - APT'
Arbitrage pricing theory is an asset pricing model based on the idea that an asset's returns can be
predicted using the relationship between that asset and many common risk factors. Created in 1976
by Stephen Ross, this theory predicts a relationship between the returns of a portfolio and the returns
of a single asset through a linear combination of many independent macroeconomic variables.
BREAKING DOWN 'Arbitrage Pricing Theory - APT'
The arbitrage pricing theory (APT) describes the price where a mispriced asset is expected to be. It is
often viewed as an alternative to the capital asset pricing model (CAPM), since the APT has more
flexible assumption requirements. Whereas the CAPM formula requires the market's expected return,
APT uses the risky asset's expected return and the risk premium of a number of macroeconomic
factors. Arbitrageurs use the APT model to profit by taking advantage of mispriced securities, which
have prices that differ from the theoretical price predicted by the model. By shorting an overpriced
security, while concurrently going long in the portfolio the APT calculations were based on,
the arbitrageur is in a position to make a theoretically risk-free profit.
Arbitrage Pricing Theory Equation and Example
APT states that the expected return on a stock or other security must adhere to the following
relationship:

Expected return = r(f) + b(1) x rp(1) + b(2) x rp(2) + ... + b(n) x rp(n)

Where,

r(f) = the risk-free interest rate

b = the sensitivity of the asset to the particular factor

rp = the risk premium associated with the particular factor

The number of factors will range depending on the analysis. There can be a few or dozens; it
depends on which factors an analyst chooses for the analysis. In addition, the exact factors do not
have to be the same across analyses. As an example calculation, assume a stock is being analyzed.
The following four factors have been identified, along with the stocks sensitivity to each factor and the
risk premium associated with each factor:

Gross domestic product growth: b = 0.6, rp = 4%

Inflation rate: b = 0.8, rp = 2%

Gold prices: b = -0.7, rp = 5%

Standard and Poor's 500 index return: b = 1.3, rp = 9%

The risk-free rate is 3%.

Using the above APT formula, the expected return is calculated as:

Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%) = 15.2%

CAPM vs. Arbitrage Pricing Theory: How They Differ

In the 1960s, Jack Treynor, William F. Sharpe, John Lintner and Jan Mossin developed the capital asset
pricing model (CAPM) to determine the theoretical appropriate rate that an asset should return given the level
of risk assumed. Thereafter, in 1976, economist Stephen Ross developed the arbitrage pricing theory (APT) as
an alternative to the CAPM. The APT introduced a framework that explains the expected theoretical rate of
return of an asset, or portfolio, in equilibrium as a linear function of the risk of the asset, or portfolio, with
respect to a set of factors capturing systematic risk.

Capital Asset Pricing Model

The CAPM allows investors to quantify the expected return on investment given the investment
risk, risk-free rate of return, expected market return and beta of an asset or portfolio. The risk-free
rate of return that is used is typically the federal funds rate or the 10-year government bond yield.

An asset's or portfolio's beta measures the theoretical volatility in relation to the overall market. For
example, if a portfolio has a beta of 1.25 in relation to the Standard & Poor's 500 Index (S&P 500), it
is theoretically 25% more volatile than the S&P 500 Index. Therefore, if the index rises by 10%, the
portfolio rises by 12.5%. If the index falls by 10%, the portfolio falls by 12.5%.

CAPM Formula
The formula used in CAPM is: E(ri) = rf + i * (E(rM) - rf), where rf is the risk-free rate of return, i is
the asset's or portfolio's beta in relation to a benchmark index, E(rM) is the expected benchmark
index's returns over a specified period, and E(ri) is the theoretical appropriate rate that an asset
should return given the inputs.

Arbitrage Pricing Theory

The APT serves as an alternative to the CAPM, and it uses fewer assumptions and may be harder to
implement than the CAPM. Ross developed the APT on a basis that the prices of securities are
driven by multiple factors, which could be grouped into macroeconomic or company-specific factors.
Unlike the CAPM, the APT does not indicate the identity or even the number of risk factors. Instead,
for any multifactor model assumed to generate returns, which follows a return-generating process, the
theory gives the associated expression for the assets expected return. While the CAPM formula
requires the input of the expected market return, the APT formula uses an asset's expected rate of
return and the risk premium of multiple macroeconomic factors.

Arbitrage Pricing Theory Formula

In the APT model, an asset's or a portfolio's returns follow a factor intensity structure if the returns
could be expressed using this formula: ri = ai + i1 * F1 + i2 * F2 + ... + kn * Fn + i, where ai is a
constant for the asset; F is a systematic factor, such as a macroeconomic or company-specific factor;
is the sensitivity of the asset or portfolio in relation to the specified factor; and i is the asset's
idiosyncratic random shock with an expected mean of zero, also known as the error term.

The APT formula is E(ri) = rf + i1 * RP1 + i2 * RP2 + ... + kn * RPn, where rf is the risk-free rate of
return, is the sensitivity of the asset or portfolio in relation to the specified factor and RP is the risk
premium of the specified factor.

Differences Between CAPM and APT

At first glance, the CAPM and APT formulas look identical, but the CAPM has only one factor and one
beta. Conversely, the APT formula has multiple factors that include non-company factors, which
requires the asset's beta in relation to each separate factor. However, the APT does not provide
insight into what these factors could be, so users of the APT model must analytically determine
relevant factors that might affect the asset's returns. On the other hand, the factor used in the CAPM
is the difference between the expected market rate of return and the risk-free rate of return. Since the
CAPM is a one-factor model and simpler to use, investors may want to use it to determine the
expected theoretical appropriate rate of return rather than using APT, which requires users to quantify
multiple factors.