Table of Contents

1 SECTION ONE ............................................................................................................................. 1 1.1 HOW TO CHOOSE THE RIGHT MEASURE OF RISKS .................................................................. 1 Definition of risk ............................................................................................................. 1 Risk measures ................................................................................................................ 1 Choice of risk measures .................................................................................................. 4 Criteria for selecting the right measure of the risk .......................................................... 5 CONCLUSION.................................................................................................................. 6

1.1.1 1.1.2 1.1.3 1.1.4 1.1.5 2

SECTION TWO ............................................................................................................................ 7 2.1 Definition of terms ................................................................................................................. 7 Net present value (NPV) ................................................................................................. 7 Security Market Line (SML) ............................................................................................. 7

2.1.1 2.1.2 2.2 2.3 2.4 2.5 3

The Cost of Capital ................................................................................................................. 7 THE SML VS NPV .................................................................................................................... 8 Reasons ................................................................................................................................. 8 Conclusion ............................................................................................................................. 9

SECTION THREE ........................................................................................................................ 9 3.1 Measures of Performance evaluation..................................................................................... 9 Treynor Measure ............................................................................................................ 9 Sharpe Ratio ................................................................................................................. 10 Jensen Measure ........................................................................................................... 11

3.1.1 3.1.2 3.1.3 4

REFERENCES ............................................................................................................................ 13

SECTION ONE

1.1 HOW TO CHOOSE THE RIGHT MEASURE OF RISKS

1.1.1 Definition of risk Risk is defined as the possibility that the actual future returns will deviate from the expected returns. In other words, it represents the variability of returns. Many possible definitions of risk have been proposed in the literature because different investors adopt different investment strategies in seeking to realize their investment objectives. It was hard to discriminate between good and bad risk measures. However, the analysis proposed by Artzner, et al. (2000) was addressed to point out the value of the risk of future

wealth, while most of portfolio theory has based the concept of risk in strong connection with
the investors preferences and their utility function. From an historical point of view, the optimal investment decision always corresponds to the solution of an expected utility maximization problem. Therefore, although risk is a

subjective and relative concept we can always state some common risk characteristics in
order to identify the optimal choices of some classes of investors, such as Risk tolerable, risk neutral and risk-averse investors. 1.1.2 Risk measures
1.1.2.1 Variance

Since the introduction of Mean Variance (MV) Analysis by Markowitz (1952), Variance (or Standard deviation) is the most common risk measure that is used by practitioners and researchers (Evans, 2004). Variance is measured by the dispersion of a return distribution

around the mean or average. While, standard deviation is the square root of the variance.
It should be noted that the model has several strict assumptions such as asset return distribution must be normally distributed and all investors have a constant quadratic utility function However, substantial studies have demonstrated that returns from real estate are not necessarily normally distributed. Besides, Sharpe and Alexander (1990) also argue that no compelling reason for assuming all investors have a static quadratic utility function.

OTHER RISK MEASURES In some applications, stock returns are not normal and so variance may not be the best measure of risk for a stock or portfolio. Many studies have proposed alternative risk measures in line with the motivation for overcoming the limitations of variance. In addition, there are other measures for risk that are easier to be interpreted. Other risk measures have been developed and applied includes:
1.1.2.2

Coefficient of Variation Beta Coefficient Semi-variance Mean Absolute Deviation (MAD) Value at Risk Lower Partial Moment (LPM) MiniMax Subjective estimates
Coefficient of Variation

Standard deviation is an absolute measure of variability; it is generally not suitable for comparing investments with different expected returns. In these cases, the coefficient of variation provides a better measure of risk. The coefficient of variation is the relative measure of variability since it measures the risk per unit of the expected return. As the coefficient of variation increases, so does the risk of an asset. In general, when comparing two equal sized investments, the standard deviation is an approximate measure of total risk. When comparing two investments with different expected returns, the coefficient of variation is more appropriate measure of total risk.
1.1.2.3 Beta Coefficient

This is mathematical value that measures the risk of one asset in terms of its effects on the risk of a group of assets called portfolio. It is solely with market related risk, as would be concerned for an investor holding stocks and bonds.

It is derived mathematically so that a high beta indicates a high level of risk and a low beta represents a low level of risk.
1.1.2.4 Semi-Variance

Semi-variance (also called downside risk or downside variance) simply assumes that the investor only cares about large shifts in the price of a stock if the large shifts are down. If the distribution is symmetric, then semi-variance is simply a multiple of variance and so no new

information is recorded. If the distribution is not symmetric, then semi-variance does capture
useful information.
1.1.2.5 Mean Absolute Deviation

Mean Absolute Deviation (MAD) is proposed by Konno (1989), which is used to overcome the limitations of Mean Variance (MV) model. The MAD measure has a number of attractive features such as easier solving procedure. So it requires a shorter computation time and improves the computation of optimal portfolios. Moreover, MAD is more stable over time than variance which it is less sensitive to outliers

and it does not require any assumption on the shape of a distribution. Interestingly, it retains
all the positive features of the MV model (Byrne and Lee, 1997). However, the computation time is less significant nowadays due to the advancement of computer. Additionally, it leads greater estimation risk that outweighs the benefits (Simaan,

1997).
1.1.2.6 Value at Risk

Value at risk is perhaps the most used of the alternate risk measures. It records the actual loss that would occur if the returns were in the worst n percent of the distribution. As with the

semi-variance, when the distribution of returns is normal, then the value at risk is a multiple
of the variance. Even in this situation where the two measures really provide the same information, some clients will demand a report of value at risk for a portfolio.
1.1.2.7 Lower Partial Moment

Lower Partial Moment (LPM) is also known as downside risk. It relies upon safety first rule,
which is developed by Roy (1952). It measures only the likelihood of bad outcomes that is the likelihood of return below the target return for an investment. It must be noted that semivariance is a special case of the LPM

The advantages of the LPM have been demonstrated, that it appears some theoretical superiorities such as no assumption on asset return distribution and set free investors from the

assumption of quadratic utility function (Lee et al., 2005). However, Hamelink and Hosli
(2004) argue that it does not consider the issue of serial correlation of returns
1.1.2.8 MiniMax

The rule uses minimum return as a measure of risk rather than variance. A MiniMax portfolio

is defined as minimising the maximum loss, where loss is defined as negative gain. It can
also alternatively defined as, maximizes the minimum gain (Young, 1998). MiniMax can be viewed as a special case of the Conditional Value at Risk as it represents the maximum loss over all past historical returns (Biglova et al., 2004). It also ignores the assumption of asset return distribution is normally distributed and it more consistent with investors utility functions, particularly, investors who have a strong aversion to downside risk. However, MiniMax rule is subject to the limitation of requiring sufficient historical data on the past returns and a predictive probability model for future returns.
1.1.2.9 Subjective estimates

A subjective risk measure occurs when qualitative rather than quantitative estimates are used to measure dispersion. As an example, an analyst may estimate that a proposal offers a low level of risk. This means that in the analysts view, the dispersion of returns will not be very wide. Similarly, a high risk level will accompany a project whose forecast returns may vary a great

deal. But for the purpose of an investment, this method is not suitable to be the right measure
of the risk. 1.1.3 Choice of risk measures Obviously, each risk measure has its advantages and disadvantages. In other words, in certain

circumstance, certain risk measure is more suitable to be used than other risk measures.
Variance is the most popular risk measure and it emerges as a risk measure that is more suitable for individual investors who normally have some basic background on risk management and the computation of variance is not as complex as other risk measures. While, variance is the only risk measure requires assumption on the asset return distributions.
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On the other hand, LPM and MiniMax could be a better choice for investors (risk seekers or strong risk aversion investors) who require a risk measure that is consistent with investors

degree of risk aversion.

While, MAD is appropriate for those desire a stable risk measure that less sensitive to outliers over the period of study. Institutional investors who have a large scale of portfolio (more than 1,000 assets); MAD is more favourable risk measures. But, empirical evidences demonstrate

that MAD suffers from the significant estimation error. This undermines the use of MAD.
1.1.4 Criteria for selecting the right measure of the risk Positivity: The first property which should be fulfilled by a risk measure is positivity. Positivity means, either there is risk or there is no risk at all. A negative value does not make sense. Particularly, the condition that there is no risk holds if and only if investment is for the risk-free asset. A better risk measure must be positivity. Consistent with investors degree of risk aversion: It is absolutely necessary for a risk

measure to make sense. It ensures us that we can characterize the set of all the optimal
choices when either wealth distributions or expected utility depend on a finite number of parameters. This is the main reason why every risk measure is incomplete and other parameters have to be considered.

Complexity: Different risk measures could have a different impact on the complexity of the
problem given. In particular, we must take into account the computational complexity when solving large-scale portfolio selection problems. Under some circumstances, it might happen that the resulting minimization problem might be linearizable, which implies easy solution procedures; in this case, we call the risk measure linearizable. Hence, the success of some risk measures is due to the computational practicability of the relative linearizable optimization problems. Effect of diversification: Another important property which should be accounted for by the

risk measure is the effect of diversification: if the wealth WA bears risk A and investment
WB bears risk B, then the risk of investing half of the money in the first portfolio and half of the money in the second one should be not be greater than the corresponding weighted sum of the risks.

Translation invariance: The last property of risk measures is called translation invariance. This property can be interpreted as follows: the risk of a portfolio cannot be reduced or

increased by simply adding a certain amount of riskless money. This property is, for example,
fulfilled by the standard deviation but not fulfilled by the MiniMax measure or the Conditional Value at Risk (CVaR) measure that has recently been suggested for risk management.

Other criteria can be summarized in table form as follows:

Characteristics Variance CV Beta Coefficient Semi-variance MAD Value at Risk LPM MiniMax Common and simple yes yes No assumption on yes yes yes yes yes yes yes return distribution Suitable for large scale portfolio yes optimization Significant estimation yes error Less sensitive to yes outliers

1.1.5 CONCLUSION In this paper, risk measures that have been mostly were reviewed. The advantages and disadvantages of each risk measure are also determined. In general, there are several alternative risk measures that have been used and each risk measure has its strengths and limitations. As such, understanding the merits and drawbacks of these risk measures will assist investors to select the most appropriate risk measure in formulating a desirable risky investment strategy accordingly their investment criteria and objectives. However, researchers should continue to make contributions in the area of the way in which surveying the acceptance level of these risk measures in practice.

SECTION TWO

2.1 Definition of terms

2.1.1 Net present value (NPV) It is the present value of an investment future net cash flow minus the initial investment. If the NPV positive, the investment should be made (unless an even better investment exists), otherwise it should not 2.1.2 Security Market Line (SML) It is a line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky marketable securities. It is also referred to as the

"characteristic line". The SML essentially graphs the results from the capital asset pricing
model (CAPM). The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The security market line tells us the reward for bearing risk in financial markets. At an absolute minimum, any new investment undertakes must offer an expected return that is no worse than what the financial markets offer for the same risk. The reason for this is simply that investors can always invest for themselves in the financial markets. Investors can only benefit by finding investments with expected returns that are superior to what the financial

markets offer for the same risk. Such an investment will have a positive NPV.
To determine whether an investment has a positive NPV or not, the expected return on that new investment should be compared to what the financial market offers on an investment with the same beta. This is why the SML is so important; it tells us the rate that is accepted

for bearing risk in the economy.

2.2 The Cost of Capital

The appropriate discount rate on a new project is the minimum expected rate of return an investment must offer to be attractive. This minimum required return is often called the cost

of capital or Required Rate of Return associated with the investment.

When we say an investment is attractive if its expected return exceeds what is offered in financial markets for investments of the same risk, we are effectively using the internal rate of return (IRR) criterion.

2.3 THE SML VS NPV

The Capital Asset Pricing Model and the SML in particular give us an estimate of the normal

rate of return that is expected on assets with varying amounts of (beta) risk. The expected
return we get from the SML should be used as the discount rate in valuing investment opportunities and proposed projects. This discount rate is also referred to as the cost of capital for the project.

Once we have forecasted the cash flows from a proposed investment, we can compute the
projects Internal Rate of Return. Typically, a project will have a positive NPV if the IRR exceeds the projects cost of capital. That is, the NPV is positive if the IRR plots above the Security Market Line on a risk/return

graph.
Figure 1: THE CAPITAL ASSETS PRICING MODEL

Where: IRRA, IRRB and IRRC are Internal rate of returns of asset A, asset B and asset C respectively, Rm is the return on the market and Rf is the return on risk free asset.

Hence: From the figure 1 above; we found that internal rate of return of an asset C was
plotted above the security market line. That is to say, if an investment has a positive NPV, it would be plotted above the Security Market line (SML).

2.4 Reasons
The expected return as provided by CAPM is the risk-free rate plus risk premium. This is the
same equation used to express the Internal Rate of Return (IRR), or opportunity cost.
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Therefore the two equations are equal and the expected return implied by CAPM = IRR. An asset that plots above the SML is a positive NPV investment because it implies an economic

profit.

2.5 Conclusion
All assets will eventually plot on the SML because when an asset is overvalued (it lies below the SML), investors will recognize they are better off investing in a portfolio that earns the

SML return than the particular asset. In doing so, investors will sell the asset and prices will
fall until the value of the asset equates to a return that lies on the SML. In the long-run, markets are efficient and the potential for arbitrage is eliminated and an asset's expected rate of return will equal the Required Rate of Return.

SECTION THREE

3.1 Measures of Performance evaluation

PORTFOLIOS Returns (%) Beta Total risk (%)

A 11 0.8 10

B 14 1.5 31

Market 12 1 20

3.1.1 Treynor Measure Jack L. Treynor was the first to provide investors with a composite measure of portfolio performance that also included risk. His objective was to find a performance measure that could apply to all investors, regardless of their personal risk preferences. He suggested that there were really two components of risk: the risk produced by fluctuations in the market and the risk arising from the fluctuations of individual securities. Treynor introduced the concept of the security market line, which defines the relationship between portfolio returns and market rates of returns, whereby the slope of the line measures the relative volatility between the portfolio and the market (as represented by beta). The beta coefficient is simply the volatility measure of a stock portfolio to the market itself. The greater the line's slope, the better the risk-return trade-off. The Treynor measure, also known as the reward to volatility ratio, can be easily defined as: (Portfolio Return Risk-Free Rate) /Beta

The numerator identifies the risk premium and the denominator corresponds with the risk of the portfolio. The resulting value represents the portfolio's return per unit risk. =

Where: = Portfolio Return, = Risk Free Rate and

= Beta

11 6 = 6.25% 0.8 14 6 = = 5.333% 1.5 12 6 = = 6% 1

3.1.1.1

Comments

The higher the Treynor measure, the better the portfolio. If you had been evaluating the portfolio on returns alone, you may have by mistake identified portfolio B as having yielded the best results. However, when considering the risks that each portfolio took to attain their

respective returns, portfolio A demonstrated the better outcome. In this case, the portfolio A
performed better than the aggregate market while the portfolio B underperformed the market. Because this measure only uses systematic risk, it assumes that the investor already has an adequately diversified portfolio and, therefore, unsystematic risk is not considered. As a

result, this performance measure should really only be used by investors who hold diversified
portfolios. 3.1.2 Sharpe Ratio The Sharpe ratio is almost identical to the Treynor measure, except that the risk measure is the standard deviation of the portfolio instead of considering only the systematic risk, as represented by beta. Conceived by Bill Sharpe, this measure closely follows his work on the capital asset pricing model (CAPM) and by extension uses total risk to compare portfolios to the capital market line. The Sharpe ratio can be easily defined as: (Portfolio Return Risk-Free Rate) / Standard Deviation =

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Where: = Portfolio Return, = Risk Free Rate and = Standard Deviation 11 6 = 0.5% 10 14 6 = = 0.258% 31 12 6 = = 0.3% 20 =
3.1.2.1 Comments

Once again, we find that the best portfolio is not necessarily the one with the highest return. Instead, it's the one with the most superior risk- adjusted return, or in this case the fund headed by portfolio A. Unlike the Treynor measure, the Sharpe ratio evaluates the portfolio manager on the basis of both rate of return and diversification. Therefore, the Sharpe ratio is more appropriate for well diversified portfolios, because it more accurately takes into account the risks of the portfolio. 3.1.3 Jensen Measure Like the previous performance measures discussed, the Jensen measure is also based on CAPM. Named after its creator, Michael C. Jensen, the Jensen measure calculates the excess return that a portfolio generates over its expected return. This measure of return is also known as alpha. The Jensen ratio measures how much of the portfolio's rate of return is attributable to the manager's ability to deliver above-average returns, adjusted for market risk. The higher the ratio, the better the risk-adjusted returns. A portfolio with a consistently positive excess return will have a positive alpha, while a portfolio with a consistently negative excess return will have a negative alpha The formula is broken down as follows: Alpha = Portfolio Return Risk-Free Rate + Beta (Return of Market Risk-Free Rate) = [ + ] Where: = Portfolio Return, = Risk Free Rate, = Beta and Markert return

= 11 [6 + 0.8 12 6 ] = 0.2% = 14 [6 + 1.5 12 6 ] = 1%

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3.1.3.1

Comments

Likewise here portfolio A did best. Treynor and Sharpe ratios examine average returns for the total period under consideration for all variables in the formula (the portfolio, market and risk-free asset). Like the Treynor measure, however, Jensen's alpha calculates risk premiums in terms of beta (systematic) and therefore assumes the portfolio is already adequately diversified. As a result, this ratio is best applied with diversified portfolios.

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Finance

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Biglova A., Ortobelli S., Rachev S., and Stoyanov S., (2004). Different approaches to risk estimation in portfolio theory, Journal of Portfolio Management Byrne, P. & Lee, S. (1997) Real Estate Portfolio Analysis under Conditions of NonNormality: The Case of NCREIF, Journal of Real Estate Portfolio Management Evans, J.L. (2004) Wealthy Investor Attitudes, Expectations, and Behaviours toward Risk and Return, The Journal of Wealth Management

Hamelink, F. & Hosli, M. (2004) Maximum Drawdown and the Allocation to Real Estate,
Journal of Property Research Konno, H. (1989) Piecewise Linear Risk Functions and Portfolio Optimisation, Journal of the Operations Research Society of Japan, Lee, C.L., Robinson, J. & Reed, R. (2005) Mean Variance Analysis versus Downside Risk Framework: Reviewing the Application of Both Frameworks in Real Estate Market. Markowitz, H. (1952). Portfolio selection, Journal of Finance Roy, A.D., (1952). Safety-first and the holding of assets. Econometrica Sharpe, W.F. & Alexander, G.J. (1990) Investments: Fourth Edition (Englewood Cliffs, New Jersey, Prentice Hall).

Simaan, Y. (1997) Estimation Risk in Portfolio Selection: The Mean Variance Model versus
the Mean Absolute Deviation Model, Management Science, Young, M.R. (1998). A MiniMax portfolio selection rule with linear programming solution: Management Science

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