Downside RiskUrvi Surti
Risk is the uncertainty of losing money invested in a security. To measure the risk or volatility of security we use Standard deviation. Standard deviation measures risk based on returns of security that are positive as well as negative. Therefore Standard deviation measures upside risk as well as downside risk. As there is a risk and return trade-off, we say an investor should be compensated in terms of returns for the risk that he takes. But why would an investor be paid for the upside deviation, an investor should be worried about the downside deviation(risk)?
What is Downside Risk?
An estimate of a security’s potential to suffer a decline in value if the market condition changes or the amount of loss that could be sustained due to decline is known as Downside Risk. It is a financial risk that is related to losses. The downside risk is the probability that the price of the asset will fall. In the case of downside risk calculation, we consider returns below the minimum acceptable return. A minimum acceptable rate of return (MARR) is the minimum profit an investor expects to make from an investment, taking into account the risks of the investment and the opportunity cost of undertaking it instead of other investments.
Down-side risk facilitates a portfolio manager with the flexibility to set the minimum acceptable level as per the investor’s requirement. He can change the Minimum Acceptable Rate depending on the desired risk parameters. For example, he could set the Minimum Acceptable Rate at “0” if he only wants to measure the times when the returns fall below 0, or have the Minimum Acceptable Rate change to match a “risk-free” asset (i.e. 3 months t-bills) that moves over time. this can also be a term.
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- Time Horizon: Time Horizon is the most critical parameter for risk analysis and it becomes a very critical parameter in downside risk. It helps in limiting our transactions for a particular period of time, making our calculations more precise. A proper sample space is essential to ensure that the time horizon is not biased and is free from cyclic deviations.
- Confidence Interval: Statistics is a base of downside side; therefore, proper and definite confidence formula is to be selected as all further calculations depend on it. It should depend on the comfort level of the investor or institution that carries out the analysis.
How to Calculate Downside Risk?
It can be calculated in many ways like:
- Standard Deviation
- Expected Shortfall
- VAR (historical simulation, variance-covariance)
The main aim is to calculate the maximum an investor can lose based on a sample space for a particular time horizon and confidence interval.
For the Variance-covariance method, we use,
VAR = – Z (z- value based on confidence interval) X Std. deviation
The deviation is calculated using historical data. Therefore another important factor to be considered while calculating downside deviation is the time horizon of security. For example, if downside deviation is calculated for security when the market was at a boom or the economy is at its peak the downside deviation calculated will be at its lowest value and therefore would not provide an accurate picture. It should be essential to include proper sample space to make sure the time horizon the manager selected is unbiased and is free from cyclic deviations. There can be many ways to calculate the downside risk. You can use standard deviation, expected shortfall, or value at risk, which has multiple methods like historical simulation, variance-covariance, etc. The aim is to calculate the maximum you can lose based on the sample space (underlying data) for a particular time horizon and investors’ expectations.
Protection Strategies against Downside Risk:
- Diversification: The simplest and the most traditional way of managing downside risk is diversification. Along with traditional assets, it is important to add alternative assets that are less correlated to market drivers as it helps in reducing risk.
- Tactical Asset Allocation: It is a market timing strategy that allocates assets on the basis of changing economic and market conditions. It allocates portfolio assets to different asset classes and can also decrease exposure to volatile assets or asset classes during a market downturn. It helps in mitigating this risk by targeting specific equities that are less sensitive to market movements.
- Use of Derivative Instruments: Derivative instruments are used to hedge against downside risk and limit market damage.
- Other Assets: Volatility cap strategies are used where an investor sets the maximum acceptable volatility and will limit the risk exposure if the limit is breached.
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The downside risk is a preventive measure as it helps in eliminating or preparing better for such scenarios. In short, it explains a worst-case scenario for investment or indicates how much the investor stands to lose.
Author: Urvi Surti and Divya Sankhla
About the Author:
Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).
Divya has completed her graduation in Bachelors of Accounting and Finance. She has worked in Deloitte Touche Tohmatsu Services, Inc. as a Research Analyst for 1 year and at JM financial as a Credit Risk Analyst for 1.3 years. She is keen on learning about Financial Market. Well-versed with Bloomberg, Capital Line, and Excel.