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see rise in risk aversion

Risk

When looking at the potential return on an investment, you should also look at the risk and the liquidity.

Risk Definitions

An asset might have a real rate of return which is different than was expected. People saving money do not like risk and are hesitant to hold assets with a high degree of uncertainty in their return. Fluctuating returns are seen as high volatility and reduce the savers desire to hold the asset.

In finance, risk is the probability that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment. It is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment.

Measuring Risk

To measure the risk of a portfolio of investments, you need to see how closely the expected return is clustered around the average return. The spread, or dispersion, of the returns over time will tell you how likely that the future return will be as expected. The two most common tools for measuring dispersion risk are standard deviation and variance.

Measure volatility is because it is a great measure of risk.  The higher the volatility, the higher the standard deviation of expected returns.  Because returns are less certain, the level of risk is higher.

On the other hand, investments in options becomes more valuable as volatility rises. Why?  because there is a greater chance that (due to the higher volatility), you might be "in the money".  See our discussion on Options for more details..

Risk-free rate

see T-bills for the US risk-free rate

Solency Risk

Measuring the 'Fiscal-Fitness' of a company: The Altman Z-Score

In the early 60's Edward Altman, using Multiple Discriminant Analysis combined a set of 5 financial ratios to come up with the Altman Z-Score. This score uses statistical techniques to predict a company's probability of failure using the following 8 variables from a company's financial statements:

http://www.creditguru.com/CalcAltZ.shtml

go here for a neat calculator

Altman's Z-Score

The 5 financial ratios in the Altman Z-Score and their respective weight factor is as follows:

These ratios are multiplied by the weightage as above, and the results are added together.

Z-Score = A x 3.3 + B x 0.99 + C x 0.6 + D x 1.2 + E x 1.4

The Interpretation of Z Score:

Z-SCORE ABOVE 3.0 -The company is safe based on these financial figures only.

Z-SCORE BETWEEN 2.7 and 2.99 - On Alert. This zone is an area where one should exercise caution.

Z-SCORE BETWEEN 1.8 and 2.7 - Good chances of the company going bankrupt within 2 years of operations from the date of financial figures given.

Z-SCORE BELOW 1.80- Probability of Financial embarassment is very high.

Explanation of Altman's Z-Score:

Altman's Z-Score formula weighs five ratios then adds them together to come up with a bankruptcy prediction estimate for a company.  This estimate of bankruptcy for publicly-held companies depends on the resulting score of Altman's Z-Score formula, which the score is divided into four categories:

Importance of Altman's Z-Score:

A score greater than 3.0, or an increasing Altman's Z-Score is usually a positive sign.  The higher the score, the better the company's chances of avoiding bankruptcy, but this score should be checked against other companies and industry standards. It should be noted that large economic events, like an entire industry slowdown, would render this scoring method less accurate.  The individual components of this formula should be monitored, as they are the key to understanding how the score was calculated.

More links

see also:

risk-premium

return

T-bills

Finance