The term ‘risk’ and the market risk as a factor of the product risk
The assessment of risks of investment products has not just been an issue within investment advice since the financial crisis 2008 or since the various, new regulation requirements concerning investor protection came into force. Key risk figures are increasingly taken into account in the advice of private clients ever since. This is certainly also due to the wider use of software solutions for the advisory process, which facilitate a recurring, easy assessment of a large universe of investment products.
In this multiple-part series of articles we aim to cast light on the topic of risk of investment products. We would like to give our readers a deeper insight into the individual risk factors as well as the common key risk figures, which can be used for investment consulting by financial service providers. The series of articles solely refers to the risk of an individual investment product and does not consider any portfolio aspects. More information on the assessment of portfolios will follow in a separate seriesIn dieser mehrteiligen Artikelserie möchten wir das Thema Risiko von Anlageprodukten beleuchten und unseren Lesern die einzelnen Risikofaktoren sowie die gängigen Risikokennzahlen näherbringen, welche von Finanzdienstleistern für die Vermögensberatung eingesetzt werden können. Die Artikelserie bezieht sich ausschliesslich auf das Risiko eines einzelnen Anlageproduktes und berücksichtigt keine Portfoliorisikoaspekte. Weitere Informationen zur Bewertung von Portfolios werden in einer separaten Artikelserie folgen.
The term ‘risk’
Risk is a widely debated term and especially at financially uncertain times it is on everyone’s mind. In financial industries we talk about financial risks, which generally can be divided into three different risk factors. These are: market risk, credit risk and liquidity risk. The risk, independent of the risk factor, is generally always connected to uncertainty and cannot always be grasped intuitively.
This can be illustrated using a simple example:
Let us assume that we place CHF100 into a bank account and look at two possible outcomes of the result after the investment period:
- Version 1: results in a guaranteed value of CHF 70
- Version 2: results in a value between CHF 150 and 250
Using the assumption that risk is defined as volatility, version 1 has no risk and version 2 has a high risk. This is why the term ‘risk’ in financial industries is often complemented by another term – for instance with the Value at Risk (VaR). In the sequel, we would like to examine the risk factor ‘market risk’ more closely. The focus in this first part of the article series is especially on volatility as a key risk figure.
Interested in more information?
Please contact us.
‘Market Risk‘ as a risk factor
Market risk, also known as market price risk or market price change risk, is the risk that results for the market participant from a change in the market value. Although market risk is immanent to every holding, it is difficult to find a consensus on how to define it. Different quantities are used to define and measure risk. The perception of risk also differs among the financial market participants and is linked to the composition of the respective portfolio, the investor type (private or institutional) and the risk aversion (and risk appetite) and risk-bearing capacity of the investor. In this post, we deal with volatility, which is one of the most well-known key figures that are used to measure market risk of investment products.
Volatility as the extent of the fluctuations
The extent of the fluctuations of (exchange) traded securities and commodities within a specific time period is labelled volatility. It influences the value and return of investment products. Traded prices are subject to a constant up and down. This applies to all investment products, such as equity shares, bonds, derivatives, foreign currency, precious metals or raw materials. The price fluctuations are dependent on the type of the instrument, the market and on specific factors that are relevant for individual securities. Depending on the instrument, the volatility is calculated from the time series of the absolute changes , the relative changes or the logarithmic changes . Absolute value changes can, for instance, be used to determine the volatility of interests. Relative and logarithmic value changes hardly differ with small changes and are, for instance, used for stochastic modelling of share prices.
Historical and implicit volatility
In the world of finance, we come across various volatility terms, such as the historical or implicit volatility. Volatility that is calculated using time series of historical value changes is termed historical or historically observed volatility. This volatility is mostly used to quantify the risk of assets or portfolios in a wealth management environment.
Based on these data points, the volatility can be calculated using the following formula:
N being the number of data points and the mean value of the return. If you, for instance, want to scale the daily volatility to a yearly volatility (where we assume 252 trading days per year), you can do this with the help of the following formula:
where the subscript a and d stand for annual and daily.
In the example above, the daily volatility over the observation period was for Google and for Apple, this corresponds to yearly volatilities of and respectively.
In the field of financial mathematics there is another volatility term, namely the term of implicit volatility. In contrast to historical volatility, implicit volatility is not based on historic time series but is derived from market prices of options. It is the volatility that reproduces the market prices when inserted in an option price model (e.g. Black-Scholes).
The different expiry dates and the strike prices result in a matrix of implicit volatilities. This is often visualised via the volatility surface.
As aforementioned, historical volatility is the risk measure that is often used in the wealth management field to determine the risk of individual securities or portfolios. Nevertheless, a critical view of volatility as the sole risk measure is necessary. This is illustrated by following points:
- The observation of historical volatility does not provide a reliable prediction for the future volatility.
- Volatility does not differentiate between up or downward price movements – few investors are concerned with price increases.
- Volatility is not a constant but can vary over the course of time and can change significantly, especially during times of crisis.
Therefore, we will introduce other market risk measures in the next post. Together with volatility these will provide a more detailed picture of the actual market risk of an investment.