Estimating the risk of a
stock I (‘Total Risk’)
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Recap: What is Risk?
Risk can have many meanings and
measures.
Ricciardi (2008) lists 188+ types of risk in the
traditional & behavioural finance literature.
Ricciardi, V. 2008. ‘Risk: Traditional Finance versus Behavioral Finance.’ In Handbook of Finance, 3: Valuation, Financial Modeling and
Quantitative Tools, pp. 11 – 38. Hoboken, NJL John Wiley & Sons, Inc.
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Recap: What is Risk?
The general consensus is that it’s the
likelihood or value of you losing your
money.
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Exploring Risk
Generally speaking, all stocks are
impacted by 2 types of risk:
Ø Firm specific risk
Ø Market risk
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Exploring Risk
Become insolvent (go bankrupt),
Firms
face leadership issues, make
could... poor decisions, scandals, etc.
Reasons your
Markets Inflation, deflation, recession, investments are
depression, political turmoil, risky.
could
changes in interest rates, natural
face... calamities, etc.
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Exploring Risk
The ‘Total Risk’ of any stock / firm is then:
Total Risk = Market Risk + Firm Specific Risk
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Measuring Total Risk
A generally accepted measure of the Total
Risk of stocks is its volatility (i.e., its
‘Standard Deviation’).
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Remember this graph?
"#$
! "#$ = 0.13%
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Volatility ≈ Risk
The greater the disparity between "# and
$["# ], the greater the volatility of '.
And the greater the risk of j.
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Volatility ≈ Risk
The volatility (risk) of a stock j increases
as (#$ − & #$ ) increases.
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Deviations of Returns
We define ("# − % "# ) as ‘deviations’.
Because this value represents the deviation
from the mean expectation.
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Deviations of Returns
"#$
! "#$ = 0.13%
"#$ − !["#$ ]
"#$ − !["#$ ] "#$ − !["#$ ]
"#$ − !["#$ ]
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Sum of Deviations
Adding each deviation for all observations
gives us the sum of all deviations.
This value will always be equal to 0.
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Sum of Deviations = 0
That’s because positive deviations cancel
off negative deviations, resulting in a net
effect of 0.
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Sum of Deviations
%
! &' − ) &' =0
"#$
&'$ − ) &' + &'- − ) &' + ⋯ + &'% − ) &' =0
$
This only holds if ) &' = ∑%"#$ &'
%
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Application (Manual, FB)
2
Date !"# $%& $%& – ([$%&] 1
( $"# = . $"#
Jan 02, 2018 181.42 #N/a #N/a -
/01
Jan 03, 2018 184.67 0.017914232 0.010870265
Jan 04, 2018 184.33 -0.001841122 -0.008885089
Jan 05, 2018 186.85 0.013671133 0.006627167 Sum = 0
Jan 08, 2018 188.28 0.007653198 0.000609231
Jan 09, 2018 187.87 -0.002177608 -0.009221574
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Sum of Deviations
! &' − ) &' = 0,∀ . ∈ 0
"#$
Where:
&' = Return on a stock .
) &' = Expected Return on a stock .
∀ . = For all . belonging to any asset class ‘A’.
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Sum of Deviations
Evidently, the sum of deviations by itself is
of little value to us.
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Sum of Squared Deviations
We can overcome the zero-sum issue by
using the sum of squared deviations
(“SSD”).
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Sum of Squared Deviations
(
-
!!" = $ )* − , )*
%&'
- - -
!!" = )*' − , )* + )*- − , )* + ⋯ + )*( − , )*
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Sum of Squared Deviations
Squared deviations ensure that volatility is
always expressed as a positive number.
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Sum of Squared Deviations
It also ensures that a value of 0 can
reasonably be interpreted as ‘risk-free’.
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Sum of Squared Deviations
Finally, it ensures that deviations are
penalised appropriately.
So that stocks with large deviations are
interpreted as more risky (and vice-versa).
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Variance of a Stock
Sum of Squared Deviations, divided by
! − 1 gives us the ‘variance’; a measure
for volatility.
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Variance of a Stock
-
1 / /
!"# #$ = ) #$ − . #$ ≡ 1$
'−1
*+,
Where:
#$ = Return on a stock 2
. #$ = Expected Return on a stock 2
' = Total number of ‘time series’ observations.
!"# #$ ≡ 1$/ = Variance of the returns on a stock 2
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Variance of a Stock (! − 1 rationale)
We divide the SSD by ! − 1 because this
is the ‘unbiased estimator’ of the ‘true’
variance.
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Variance of a Stock
,
1 #
!"# = ( -" − . -"
&−1
)*+
# # #
-"+ − . -" + -"# − . -" + ⋯ + -", − . -"
!"# =
&−1
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Variance of a Stock
While the variance is a measure of
volatility (risk), its interpretation is limited.
It also tends to be a very small number.
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Standard Deviation of a Stock
We overcome the limitations of the
variance by taking its square root.
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Standard Deviation of a Stock
This also ensures that the value is
expressed in percentage terms.
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Standard Deviation of a Stock
This makes it easier to compare the risk
with the return.
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Standard Deviation of a Stock
-
1 /
!" #$ = ) #$ − . #$ ≡ 1$
'−1
*+,
1$ = 1$/
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Standard Deviation of a Stock
The standard deviation is the risk
(volatility) of a stock.
+
1 .
!" = ' ," − - ," ≡ !".
%−1
()*
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Summary
Generally speaking, all stocks are impacted by 2 types of risk,
including:
Ø Firm Specific Risk, and
Ø Market Risk.
The ‘Total Risk’ is equal to the Market Risk + Firm Specific Risk.
A generally accepted measure of the Total Risk of a stock is its
volatility (i.e., its Standard Deviation).
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Summary
The Standard Deviation (SD) of a stock is calculated by:
+
1 .
!" = ' ," − - ," ≡ !".
%−1
()*
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Now have a go
at the quiz!
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