What is a 'Risk Asset'
As such, these
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.
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 Risk, 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 orders 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.