The capital asset pricing model (CAPM) is used to determine the expected return on any asset. The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systemic risk or market risk), beta (β), as well as the expected return of the market and the expected return of a theoretical risk-free asset.
This gives you the equation . From a direct interpolation, as beta increases the E[Ri] increases, and as beta decreases E[Ri] decreases.
When beta equals 1 then the asset moves diectly with the market. Thus, for every 1 increase in the market the asset will also increase by 1.
When beta >1 then the asset moves more than 1 for every 1 increase in the market.
When beta <1, the asset move in the opposite direction with the market. So, every 1 increase in the market the asset decreases by a factor of beta.
Also, Betai= Cov(Ri,Rm)/Var(Rm)
A downside of CAPM is that it assumes normal returns, and wouldn’t be effective today with great fluctuations in the market.
CAPM also influences the optimum portfolio, and the capital allocation line (CAL). These measure the optimum amount for you to invest in the asset under consideration and a fisk free asset.
Links:
http://en.wikipedia.org/wiki/Capital_Asset_Pricing_Model
Sunday, January 25, 2009
Risk Mismanagement:
Even tough value at risk is a valuable tool to assess risk of a trader’s portfolio, it only works when the market it behaving normally. Now risk managers cannot use VAR because of the current market fluctuations. Thus, risk managers cannot use the main tool that they have relied on for the last 10-20 years or so. The risks that VAR measured did not include the risk of a financial meltdown, which was the biggest risk of all.
David Einhorn states “VAR is a relatively useless as a risk management tool and potentially catastrophic when its use creates a false sense of security among senior managers.” Companies in the future should not rely so heavily on VAR to check its risky investments. They should use other methods, and then use VAR as a final check to evaluate their position.
The keyword here is risk itself, nothing is really risk free when there are so many complexities of the market. After all markets could change daily in how efficient they are, which effects how normal they behave. With all this training we are taught to look for inefficiencies of the market, and capitalize on them. So if just about everyone is looking for these, it is hard to say that the market is truly behaving “normally.”
Links:http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?_r=2&emc=eta1
David Einhorn states “VAR is a relatively useless as a risk management tool and potentially catastrophic when its use creates a false sense of security among senior managers.” Companies in the future should not rely so heavily on VAR to check its risky investments. They should use other methods, and then use VAR as a final check to evaluate their position.
The keyword here is risk itself, nothing is really risk free when there are so many complexities of the market. After all markets could change daily in how efficient they are, which effects how normal they behave. With all this training we are taught to look for inefficiencies of the market, and capitalize on them. So if just about everyone is looking for these, it is hard to say that the market is truly behaving “normally.”
Links:http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?_r=2&emc=eta1
Saturday, January 24, 2009
Enterprise Risk Management (ERM):
Although enterprise risk management is important to avoid potential threats that will affect the well being of a company, it is sometimes hard to quantify. The idea may seem simple, but there are many ways one can reduce risk through the use of insurance, forwards, options, and contracts. So, which one is the most effective/optimal way to reduce the uncertainty?
It depends on the company under consideration. What works for one company, may not satisfy the risk tolerance for a similar company. According to the Risk and Insurance Management Society (RIMS), “ERM is a comprehensive view of risk from both operational and strategic perspectives and is a process that supports the reduction of uncertainty and promotes the exploitation of opportunities.”
Once a business is established for a few years then it should consider investing in some type of risk management. For smaller start up business’s risk management will be harder to target, since they may not have finances to use effective risk management tools. Considering that most new business’s success depends heavily on how it does in the first year, they may not be able to benefit from their investment in risk management. There may also be some mismanagement in the first year, because a new business owner may not know what to expect in the first year.
Links:
http://en.wikipedia.org/wiki/Enterprise_risk_management
It depends on the company under consideration. What works for one company, may not satisfy the risk tolerance for a similar company. According to the Risk and Insurance Management Society (RIMS), “ERM is a comprehensive view of risk from both operational and strategic perspectives and is a process that supports the reduction of uncertainty and promotes the exploitation of opportunities.”
Once a business is established for a few years then it should consider investing in some type of risk management. For smaller start up business’s risk management will be harder to target, since they may not have finances to use effective risk management tools. Considering that most new business’s success depends heavily on how it does in the first year, they may not be able to benefit from their investment in risk management. There may also be some mismanagement in the first year, because a new business owner may not know what to expect in the first year.
Links:
http://en.wikipedia.org/wiki/Enterprise_risk_management
Foreseeing The Current Financial Crisis: a domino effect.
Even though bailout money distributed by the government was intended to lessen the financial burden of the housing market and to help banks start lending money again, the effects are non-existent. According to Global Property Guide “house prices continue to plummet, despite the government bail out packages. The 10 major cities have averaged an 18.6% drop in prices.
However, these catastrophic events could have been foreseen years ago when the housing market was weakening. I believe that there was no real value being added to accommodate the increase in prices, just a rapid increase in demand. Many of the homes there are very old, and had their own set of problems that come with age. Some were so severe that people would buy an old house for the land, demolish it, and then rebuild. Also, some people were buying homes just to fix them up and resell them. The housing market in Miami for 2006 had a median price of $377,000.
The city of Miami had such a prime housing market, that you could say that it is one of the biggest in the United States. So when the largest housing market is having problems, the rest will soon fall in due time.
In 2005 the housing market in Miami was booming with sky-high prices, yet everyone was still buying everything up. Everything was being developed and any piece of vacant land was being built upon. Even though Miami is a major city I felt that construction workers were building so many houses, strip malls, and high rises that they had over developed the city faster than it could handle. A year later when I went back the housing market had declined and realtors were discounting houses by a couple of thousand dollars to try to get rid of them.
From 2005-2008 I believe that the housing market was falsely inflated and over valuated, to promote higher prices. As the prices continued to rise, the wages of homeowners remained level. To make matters worse banks were approving loans, when they knew the potential homeowners could never afford mortgage.
Links:
http://www.globalpropertyguide.com/North-America/United-States/Price-History
http://www.miamism.com/2007-miami-dade-county-real-estate-market-conditio
http://money.cnn.com/2006/05/15/real_estate/NAR_firstQ2005_home_prices/index.htm
However, these catastrophic events could have been foreseen years ago when the housing market was weakening. I believe that there was no real value being added to accommodate the increase in prices, just a rapid increase in demand. Many of the homes there are very old, and had their own set of problems that come with age. Some were so severe that people would buy an old house for the land, demolish it, and then rebuild. Also, some people were buying homes just to fix them up and resell them. The housing market in Miami for 2006 had a median price of $377,000.
The city of Miami had such a prime housing market, that you could say that it is one of the biggest in the United States. So when the largest housing market is having problems, the rest will soon fall in due time.
In 2005 the housing market in Miami was booming with sky-high prices, yet everyone was still buying everything up. Everything was being developed and any piece of vacant land was being built upon. Even though Miami is a major city I felt that construction workers were building so many houses, strip malls, and high rises that they had over developed the city faster than it could handle. A year later when I went back the housing market had declined and realtors were discounting houses by a couple of thousand dollars to try to get rid of them.
From 2005-2008 I believe that the housing market was falsely inflated and over valuated, to promote higher prices. As the prices continued to rise, the wages of homeowners remained level. To make matters worse banks were approving loans, when they knew the potential homeowners could never afford mortgage.
Links:
http://www.globalpropertyguide.com/North-America/United-States/Price-History
http://www.miamism.com/2007-miami-dade-county-real-estate-market-conditio
http://money.cnn.com/2006/05/15/real_estate/NAR_firstQ2005_home_prices/index.htm
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