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What is a 'Risk Asset' unable to pay for the money they borrowed.

As such, these
people go into default. Investors affected by credit risk suffer
A risk asset is any asset that carries a degree of risk. Risk from decreased income and lost principal and interest, or they
asset generally refers to assets that have a significant degree deal with a rise in costs for collection.
of price volatility, such as equities, commodities, high-yield
bonds, real estate and currencies. Specifically in the banking Liquidity risk involves securities and assets that cannot be
context, risk asset refers to an asset owned by a bank or purchased or sold fast enough to cut losses in a volatile
financial institution whose value may fluctuate due to changes market. Asset-backed risk is the risk that asset-backed
in interest rates, credit quality, repayment risk and so on. The securities may become volatile if the underlying securities also
term may also refer to equity capital in a financially stretched or change in value. The risks under asset-backed risk include
near-bankrupt company, as its shareholders claims would rank prepayment risk and interest rate risk.
below those of the firms bondholders and other lenders.
Changes in prices because of market differences, political
BREAKING DOWN 'Risk Asset' changes, natural calamities, diplomatic changes or economic
conflicts may cause volatile foreign investment conditions that
Investor appetite for risk assets swings considerably over time. may expose businesses and individuals to foreign investment
The period from 2003 to 2007 was one of huge risk appetite, risk. Equity risk covers the risk involved in the volatile price
as rampant investor demand drove up prices of most assets changes of shares of stock.
associated with above-average risk, including commodities,
emerging markets, subprime mortgage-backed securities, as Investors holding foreign currencies are exposed to currency
well as currencies of commodity exporters such as Canada risk because different factors, such as interest rate changes
and Australia. The global recession of 2008 to 2009 triggered and monetary policy changes, can alter the value of the asset
massive aversion for risk assets, as capital fled to the that investors are holding.
quintessential safe-haven of U.S. Treasuries.
Financial Risk is one of the major concerns of
Since March 2009, as swings in risk appetite became more every business across fields and geographies.
pronounced due to global macroeconomic concerns, such as This is the reason behind Financial Risk
European sovereign debt (in 2010 and 2011) and the Manager FRM Exam gaining huge recognition
U.S. fiscal cliff (in 2012), market-watchers began referring to
times when investors have substantial appetite for risk assets among financial experts across the globe. FRM
as "risk on" periods and intervals of risk aversion as "risk off" is the top most credential offered to risk
periods. management professionals worldwide.
What is 'Financial Risk' Financial Risk again is the base concept of
FRM Level 1 exam. Before understanding the
Financial risk is the possibility that shareholders will lose techniques to control risk and perform risk
money when they invest in a company that has debt, if the
company's cash flow proves inadequate to meet its financial management, it is very important to realize
obligations. When a company uses debt financing, what risk is and what the types of risks are.
its creditors are repaid before its shareholders if the company Let's discuss different types of risk in this
becomes insolvent. Financial risk also refers to the possibility post.
of a corporation or government defaulting on its bonds, which
would cause those bondholders to lose money Risk and Types of Risks:
BREAKING DOWN 'Financial Risk' Risk can be referred as the chances of having
Financial risk is the general term for many different types of an unexpected or negative outcome. Any action
risks related to the finance industry. These include risks or activity that leads to loss of any type can be
involving financial transactions such us company loans, and its termed as risk. There are different types of
exposure to loan default. The term is typically used to reflect an
risks that a firm might face and needs to
investor's uncertainty of collecting returns and the potential for
monetary loss. overcome. Widely, risks can be classified into
three types: Business Risk , Non-Business Risk
Investors can use a number of financial risk ratios to assess an and Financial Risk.
investment's prospects. For example, the debt-to-capital ratio
measures the proportion of debt used, given the total capital 1. Business Risk: These types of risks are
structure of the company. A high proportion of debt indicates a taken by business enterprises
risky investment. Another ratio, the capital expenditure ratio, themselves in order to maximize
divides cash flow from operations by capital expenditures to
see how much money a company will have left to keep the shareholder value and profits. As for
business running after it services its debt. example: Companies undertake high
Types of Financial Risks cost risks in marketing to launch new
product in order to gain higher sales.
There are many types of financial risks. The most common
ones include credit risk, liquidity risk, asset backed risk, foreign 2. Non- Business Risk: These types of risks
investment risk, equity risk and currency risk. are not under the control of firms. Risks
that arise out of political and economic
Credit risk is also referred to as default risk. This type of risk is imbalances can be termed as non-
associated with people who borrowed money and who are business risk.
3. Financial Risk: Financial Risk as the Operational Risk:
term suggests is the risk that involves This type of risk arises out of operational
financial loss to firms. Financial risk failures such as mismanagement or technical
generally arises due to instability and failures. Operational risk can be classified
losses in the financial market caused by into Fraud Risk and Model Risk. Fraud risk
movements in stock prices, currencies, arises due to lack of controls and Model risk
interest rates and more. arises due to incorrect model application.
Types of Financial Risks: Legal Risk:
Financial risk is one of the high-priority risk This type of financial risk arises out of legal
types for every business. Financial risk is constraints such as lawsuits. Whenever a
caused due to market movements and market company needs to face financial loses out of
movements can include host of factors. Based legal proceedings, it is legal risk.
on this, financial risk can be classified into What is the 'Capital Asset Pricing Model - CAPM'
various types such as Market Risk, Credit Risk, The capital asset pricing model (CAPM) is a model that
Liquidity Risk, Operational Risk and Legal Risk. 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:

Market Risk:
This type of risk arises due to movement in
prices of financial instrument. Market risk can
The general idea behind CAPM is that investors need to be
be classified as Directional Risk and Non -
compensated in two ways: time value of money and risk. The
Directional Risk. Directional risk is caused due time value of money is represented by the risk-free (rf) rate in
to movement in stock price, interest rates and the formula and compensates the investors for placing money
more. Non- Directional risk on the other hand in any investment over a period of time. The risk-free rate is
can be volatility risks. customarily the yield on government bonds like U.S.
Credit Risk: Treasuries.
This type of risk arises when one fails to fulfill
The other half of the CAPM formula represents risk and
their obligations towards their counter
calculates the amount of compensation the investor needs for
parties. Credit risk can be classified taking on additional risk. This is calculated by taking a risk
into Sovereign Risk and Settlement Risk. measure (beta) that compares the returns of the asset to the
Sovereign risk usually arises due to difficult market over a period of time and to the market premium (Rm-
foreign exchange policies. Settlement risk on rf): the return of the market in excess of the risk-free rate. Beta
the other hand arises when one party makes reflects how risky an asset is compared to overall market risk
the payment while the other party fails to fulfill 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
the obligations.
is usually represented as the S&P 500 but can be represented
Liquidity Risk: by more robust indexes as well.
This type of risk arises out of inability to
execute transactions. Liquidity risk can be The CAPM model says that the expected return of a security or
classified into Asset Liquidity Risk and Funding a portfolio equals the rate on a risk-free security plus a risk
Liquidity Risk. Asset Liquidity risk arises either premium. If this expected return does not meet or beat the
due to insufficient buyers or insufficient required return, then the investment should not be undertaken.
The security market line plots the results of the CAPM for all
sellers against sell orders and buy orders
different risks (betas).
respectively.
Example of CAPM
Using the CAPM model and the following assumptions, we can often used as the discount rate in discounted cash flow, a
compute the expected return for a stock: popular valuation model.

The risk-free rate is 2% and the beta (risk measure) of a stock The Capital Asset Pricing Model: an Overview
is 2. The expected market return over the period is 10%, so No matter how much we diversify our investments, it's
that means that the market risk premium is 8% (10% - 2%) impossible to get rid of all the risk. As investors, we deserve
after subtracting the risk-free rate from the expected market a rate of return that compensates us for taking on risk.
return. Plugging in the preceding values into the CAPM formula The capital asset pricing model (CAPM) helps us to calculate
above, we get an expected return of 18% for the stock: investment risk and what return on investment we should
expect. Here we take a closer look at how it works.
18% = 2% + 2 x (10%-2%) Birth of a Model
The capital asset pricing model was the work of financial
Market Risk Premium economist (and later, Nobel laureate in economics) William
The market risk premium is the difference between Sharpe, set out in his 1970 book "Portfolio Theory and Capital
the expected return on a market portfolio and the risk-free rate. Markets." His model starts with the idea that individual
Market risk premium is equal to the slope of the security investment contains two types of risk:
market line (SML), a graphical representation of the capital 1. Systematic Risk These are market risks that cannot
asset pricing model (CAPM). CAPM measures required rate of be diversified away. Interest rates, recessions and
return on equity investments, and it is an important element of wars are examples of systematic risks.
modern portfolio theory and discounted cash flow valuation.

Market risk premium describes the relationship between 2. Unsystematic Risk Also known as "specific risk," this
returns from an equity market portfolio and treasury risk is specific to individual stocks and can be
bond yields. The risk premium reflects required returns, diversified away as the investor increases the number
historical returns and expected returns. The historical market of stocks in his or her portfolio. In more technical
risk premium will be the same for all investors since the value terms, it represents the component of a stock's return
is based on what actually happened. The required and that is not correlated with general market moves.
expected market premiums, however, will differ from investor to Modern portfolio theory shows that specific risk can be
investor based on risk tolerance and investing styles. removed through diversification. The trouble is that
Theory diversification still doesn't solve the problem of systematic risk;
even a portfolio of all the shares in the stock market can't
Investors require compensation for risk and opportunity cost. eliminate that risk. Therefore, when calculating a deserved
The risk-free rate is a theoretical interest rate that would be return, systematic risk is what plagues investors most. CAPM,
paid by an investment with zero risk, and long-term yields on therefore, evolved as a way to measure this systematic risk.
U.S. treasuries have traditionally been used as a proxy for the
risk-free rate because of the low default risk. Treasuries have The Formula
historically had relatively low yields as a result of this assumed
reliability. Equity market returns are based on expected returns Sharpe found that the return on an individual stock, or a
on a broad benchmark index such as the Standard & Poor's portfolio of stocks, should equal its cost of capital. The
500 index of the Dow Jones Industrial Average. Real equity standard formula remains the CAPM, which describes the
returns fluctuate with operational performance of the underlying relationship between risk and expected return.
business, and the market pricing for these securities reflects
this fact. Historical return rates have fluctuated as the economy Here is the formula:
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 CAPM's starting point is the risk-free rate typically a 10-year
premium can be used in important calculations such as CAPM. government bond yield. To this is added
Between 1926 and 2014, the S&P 500 exhibited a 10.5% a premium that equity investors demand to compensate them
compounding annual rate of return, while the 30-day treasury for the extra risk they accept. This equity market
bill compounded at 5.1%. This indicates a market risk premium premium consists of the expected return from the market as a
of 5.4%, based on these parameters. whole less the risk-free rate of return. The equity risk
premium is multiplied by a coefficient that Sharpe called "beta."
Beta
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
According to CAPM, beta is the only relevant measure of a Exchange and Nasdaq between 1963 and 1990, they found
stock's risk. It measures a stock's relative volatility that is, it that differences in betas over that lengthy period did not
shows how much the price of a particular stock jumps up and explain the performance of different stocks. The linear
down compared with how much the stock market as a whole relationship between beta and individual stock returns also
jumps up and down. If a share price moves exactly in line with breaks down over shorter periods of time. These findings seem
the market, then the stock's beta is 1. A stock with a beta of 1.5 to suggest that CAPM may be wrong.
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.

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
Beta, compared with the equity risk premium, shows the with betas in excess of 1 while the market is rising, and
amount of compensation equity investors need for taking on securities with betas of less than 1 when the market is falling.
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% Not surprisingly, CAPM contributed to the rise in use
(2 X 4%, multiplying market return by the beta), and the stock's of indexing assembling a portfolio of shares to mimic a
total required return is 11% (8% + 3%, the stock's excess particular market by risk-averse investors. This is largely due
return plus the risk-free rate). 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).
What this shows is that a riskier investment should earn a
The Bottom Line
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 The capital asset pricing model is by no means a perfect
parts of the CAPM, to gauge whether or not the current price of theory. But the spirit of CAPM is correct. It provides a usable
a stock is consistent with its likely return that is, whether or measure of risk that helps investors determine what return they
not the investment is a bargain or too expensive. deserve for putting their money at risk.
What CAPM Means for You
Arbitrage Pricing Theory APT
This model presents a very simple theory that delivers a simple What is the 'Arbitrage Pricing Theory - APT'
result. The theory says that the only reason an investor should
earn more, on average, by investing in one stock rather than Arbitrage pricing theory is an asset pricing model based on the
another is that one stock is riskier. Not surprisingly, the model idea that an asset's returns can be predicted using the
has come to dominate modern financial theory. But does it relationship between that asset and many common risk factors.
really work? Created in 1976 by Stephen Ross, this theory predicts a
relationship between the returns of a portfolio and the returns
It's not entirely clear. The big sticking point is beta. When of a single asset through a linear combination of many
professors Eugene Fama and Kenneth French looked at share independent macroeconomic variables.
returns on the New York Stock Exchange, the American Stock
theoretical rate of return of an asset, or portfolio, in equilibrium
BREAKING DOWN 'Arbitrage Pricing Theory - APT' as a linear function of the risk of the asset, or portfolio, with
The arbitrage pricing theory (APT) describes the price where a respect to a set of factors capturing systematic risk.
mispriced asset is expected to be. It is often viewed as an
alternative to the capital asset pricing model (CAPM), since the Capital Asset Pricing Model
APT has more flexible assumption requirements. Whereas the
CAPM formula requires the market's expected return, APT The CAPM allows investors to quantify the expected return on
uses the risky asset's expected return and the risk premium of investment given the investment risk, risk-free rate of return,
a number of macroeconomic factors. Arbitrageurs use the APT expected market return and beta of an asset or portfolio. The
model to profit by taking advantage of mispriced securities, risk-free rate of return that is used is typically the federal funds
which have prices that differ from the theoretical price rate or the 10-year government bond yield.
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 An asset's or portfolio's beta measures the theoretical volatility
make a theoretically risk-free profit. in relation to the overall market. For example, if a portfolio has
Arbitrage Pricing Theory Equation and Example 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
APT states that the expected return on a stock or other security rises by 12.5%. If the index falls by 10%, the portfolio falls by
must adhere to the following relationship: 12.5%.
CAPM Formula
Expected return = r(f) + b(1) x rp(1) + b(2) x rp(2) + ... + b(n) x
rp(n) The formula used in CAPM is: E(ri) = rf + i * (E(rM) - rf), where
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
r(f) = the risk-free interest rate 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.
b = the sensitivity of the asset to the particular factor
Arbitrage Pricing Theory
rp = the risk premium associated with the particular factor
The APT serves as an alternative to the CAPM, and it uses
fewer assumptions and may be harder to implement than the
The number of factors will range depending on the analysis. CAPM. Ross developed the APT on a basis that the prices of
There can be a few or dozens; it depends on which factors an securities are driven by multiple factors, which could be
analyst chooses for the analysis. In addition, the exact factors grouped into macroeconomic or company-specific factors.
do not have to be the same across analyses. As an example Unlike the CAPM, the APT does not indicate the identity or
calculation, assume a stock is being analyzed. The following even the number of risk factors. Instead, for any multifactor
four factors have been identified, along with the stocks model assumed to generate returns, which follows a return-
sensitivity to each factor and the risk premium associated with generating process, the theory gives the associated expression
each factor: for the assets expected return. While the CAPM formula
requires the input of the expected market return, the APT
Gross domestic product growth: b = 0.6, rp = 4% formula uses an asset's expected rate of return and the risk
premium of multiple macroeconomic factors.
Inflation rate: b = 0.8, rp = 2% Arbitrage Pricing Theory Formula

Gold prices: b = -0.7, rp = 5% 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 +
Standard and Poor's 500 index return: b = 1.3, rp = 9% i, where ai is a constant for the asset; F is a systematic factor,
such as a macroeconomic or company-specific factor; is the
The risk-free rate is 3%. sensitivity of the asset or portfolio in relation to the specified
factor; and i is the asset's idiosyncratic random shock with an
Using the above APT formula, the expected return is calculated expected mean of zero, also known as the error term.
as:
The APT formula is E(ri) = rf + i1 * RP1 + i2 * RP2 + ... + kn
Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + * RPn, where rf is the risk-free rate of return, is the sensitivity
(1.3 x 9%) = 15.2% 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
CAPM vs. Arbitrage Pricing Theory: How They Differ
In the 1960s, Jack Treynor, William F. Sharpe, John Lintner At first glance, the CAPM and APT formulas look identical, but
and Jan Mossin developed the capital asset pricing the CAPM has only one factor and one beta. Conversely, the
model (CAPM) to determine the theoretical appropriate rate APT formula has multiple factors that include non-company
that an asset should return given the level of risk assumed. factors, which requires the asset's beta in relation to each
Thereafter, in 1976, economist Stephen Ross developed the separate factor. However, the APT does not provide insight into
arbitrage pricing theory (APT) as an alternative to the CAPM. what these factors could be, so users of the APT model must
The APT introduced a framework that explains the expected 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.