Risk Measurement
"risk is an asymmetric, relative, heteroskedastic, multidimensional concept that has to take into account asymptotic behavior of returns, inter-temporal dependence, risk-time aggregation, further sources of risk, and the impact of several economic phenomena that could influence an investor’s preferences." - Desirable Properties of an Ideal Risk Measure in Portfolio Theory (2004)
Risk is a very broad and also very interesting topic. Risk has also become a bit of buzzword among practitioners as well as researchers. As risk is being addressed by regulators and industry organizations, something like a "risk industry" has evolved (similar to the "performance industry" initiated by the AIMR-PPS/GIPS). It is one of the most fundamental contributions of academic finance theory that risk and return (or performance) are essentially the same coin viewed from different sides. Among practitioners, this dichotomy is usually neglected. One of the reasons for this being the major difference between a "risk culture" (the nay sayers) and a "performance/return culture" (the value-contributors): Truly integrated risk and performance management departments will always be difficult to implement. There is also a lack of concepts: The book "Integrated Risk and Performance Management" or similar is still awaiting to be written.
In the financial the industry, no uniform model has been adopted to measure risks. But "management of risk" does require the measurement of risk in the first place.
In the context of investment performance, the presence of risk has several implications:
- Most investment returns are not known with certainty
- Most investment returns fluctuate over time
- It is possible that an observed difference in returns is due to risk only
The existence of risk results in a differentiation between 'true' and 'observed' returns, with the 'true' returns being a pure 'signal' and the 'observed' returns containing the signal and 'noise'.
Risk also causes a differentiation into 'ex post' and 'ex ante' returns: 'Ex ante' returns are the expected return at the beginning of the period, 'ex post' returns the result calculated at the end of the period. The difference between ex post and ex ante returns is basically ignorance consisting of information deficits about the true returns and factors that cannot be comprehended and controlled for.
Literature:
- Nawrocki D. (1999): "A Brief History of Downside Risk Measures", Journal of Investing, Fall, p9-26
- Holton Glyn A. (2004): "Defining Risk", Finanical Analysts Journal, Volume 60, Number 6
- Knight F. (1921): "Risk, Uncertainty and Profit", Hard, Schaffner & Marx, New York
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