Standard Deviation – Is it the right way of measuring risk

Is standard deviation the best way of measuring an inherent risk? Look at the performance of the Sensex and bonds across the last ten years. The equity market has garnered a premium of over 6-7% over the bonds in the past because of their inherent risk.

But risk is measured by the factor called standard deviation which is given by
Sqrt (Summation ((x-x bar) ^2)/n)

Now just like all other statistical measures, this measure also sees the performance/returns over a period. Say in the last ten years markets have a standard deviation of 20%. If you go on to observe carefully this 20% would have been largely driven the fact that markets collapsed in a given year or markets raised heavily in a year. These outliers have a huge effect on the market. Wonder if I could remove these outliers and calculate the standard deviation, then the numbers will be all the more comfortable for a risk adverse investor.


Now the problem with such outliers is that they push up the expectations in the market and portray a less risky security to be more risky. Now for example the long term standard deviation of the equity markets would have gone up by the fact that the markets plummeted by about 65% in the last one year . Now this will make the expected return on the market to be so risky (Now for example an investor in the market would claim that he will expect a return of 10% with a S.D of 20%-which is not true). Now this definitely misleads us because observing historically the markets have not gone down continuously in two years. Or to make myself sound more professional, the probability that the market will go down continuously in two years is negligible. Hence this essentially makes the security risk free for the investor who is currently holding. But just the fact that the standard deviation is high makes the cost of equity paid to be high and hence the companies have to look for projects with high pay off. This generally drives up the prices all round, when it could have been easily done away with if the investors had been rationale. On similar lines investor who is holding on to the stock after two or three years of nominal rise is at a heavy risk because he can claim the same returns as the investor who was holding it currently (after a big fall), but faces tremendous amount of risk because it might be more or less certain that the markets will fall.


My argument will not be valid if the same investor holds on to the stock for a prolonged period and sees in terms of the real economic growth and hence sets rational expectation. But how many of us really hold on to a stock for more than for a period of say 2 -3 years. So the person who really has a risk (holding it 4-5 after a fall) loses money and person who doesn’t have the risk (holding the stock during the first year after fall) will definetly gain money.
So contrary to the beliefs of financial pundits, is risk really bad? Or is there a better way of measuring risk?


PS: This was a post which I wrote about 4 months back and posting it after a long time . So I found the answer to my own question!! ..There are models like GARCH , EWMA which forecasts the risk based upon the past risk patterns and also factoring in some estimates of future outcomes . In fact Value at risk has been considered to be one of the best measures of quantifying risk(which again is derived from Standard deviation and mean estimates)

CVR(Valuation) project : Some useful inputs

Following are some of the practical difficulties that you might face while doing valuation and I have mentioned some ways to resolve it…

High Debt/Volatile Capital Structure: In case your firm has high D/E ratio, it has a very volatile debt structure then use Capital cash flow method to do your valuations..
Comparables: In case you can’t find data for the comparable company (To calculate Bottom up beta, to compare various multiples) in the industry or there are no real comparable company in the particular sector then expand your horizon..Move to closely allied sector and pinch some comparables from there..You can even get to pick some global companies and use them as comparables(Chose countries such as Brazil , China which have comparable growth rate as India or your sector should be in the same life cycle in that particular country)..This is little complicated stuff…I would not recommend to go to this level for an academic project (But just in case you end up in a valuation based role, impress your manager using this funda!!)

Choose the right model: In case your company is in a high growth stage: around 20-50%) then chose a three stage model..Two stage will not work in this case because you assume the high growth rate to be say 30% for 5 years..You can’t suddenly assume a stable growth rate of 7% from year 6(Because your growth will not fall so steeply)..So three stage model assumes a linear fall in growth from high growth rate to stable growth rate…And try to restrict yourself to three stage model..Going beyond three stage model will complicate things too much..Also when you are taking a three stage model make sure that you make different assumptions for the beta , ROE , ROA (Refer some typical examples in Damodaran Text book in FCFE chapter)..

Bank Valuation: In case you are amongst those poor souls valuing a bank , then the only thing I have to tell is that don’t go by the traditional methods of valuation like FCFE ..You have to be concentrating on factors like NIM for the projections (I don’t know how to do it!!)

Relative multiples :
· Ignore the value/ratio if you end up with a negative number
· In case of valuing ratios using fundamental values (Ke,g.payout) be clear that there are two different formulaes that are applicable: One for stable growth companies and other for companies in the high growth period..Use the appropriate formulae based on your company
· Use ratios which will make sense to your industry..For a technology company PEG ratio is a bare minimum and so is P/S , V/S for a FMCG
· In case you are picking numbers from database be clear which earnings figure they have used to calculate the ratio..(That would be the first q from the audience or from your boss when you present a multiple)
· In case data for a particular comparable company is not available, then don’t use that company in the ratio..Don’t do the mistake of comparing the ratio of your company in the current year with the ratio of the competitor in the previous year(It’ll make no sense..That too in the current scenario where the ratios have halved over the last one year)

Be clear with all your assumptions for your inputs:Valuation is a very subjective exercise..Hence you can take any number for your inputs..But make sure that every number you enter into your model is thoroughly backed up either fundamentals, analyst estimates, management discussion (directors report etc)..

Refer NSE website to get information regarding publicly traded bonds (to calculate the cost of debt of your bond: use the YTM of the bond if it is traded) and also to find the current RFR

Capital expenditures assumption
The projection for capital expenditure can be done in either of these ways a) Assume your Capex to be in proption of sales as in the previous year b) If there are some management estimates of the capex c) If there are some discussion about a big acquisition going to happen in the near future, then factor that into your Capex figure (Just a guesstimate!!)

Capitalise your assets/liablities
In case of an FMCG firm/Airways, don’t forget to capitalize the operating lease..You’ll end up with a figure which will be approximately 20% higher than the actual..Similarly capitalize R and D of a pharma company.

Derivatives – ‘He who must not be named’

It was almost the same time when I started reading Harry Potter and also started trading in derivatives..It was way back in 2005, third year of my college. 4 years since then, the villain of the story - Voldermot is already dead and the derivatives market – He who must not be named in the financial parlance , has collapsed the entire financial system….Was there a fundamental problem with derivatives as a concept or was there a problem in the so called innovative products into the markets..Lots and Lots of debate goes around in the financial circle.This article will not get into all such debates..This is just a primer to the world of derivatives

There are lot of derivative instruments which are used to hedge risk. I’ll introduce the most prominent among them: Forwards & Futures, Options.

Forwards &Futures: Turn into the first page of any derivative book or type in Forwards and Futures in Google and the first example you would find is,
Assume a farmer who is planning to plant some crops and is planning to harvest in about three months. He is worried about the price fluctuations that can happen to the crop prices . Hence he would like to lock his price at the current market price. So he enters into a contract with a buyer promising him to sell at a particular rate.. This rate is called the forward rate. What determines the forward rate??

Let me try explaining forward through a cricket example.Assume if Dhoni price tag (as per his current form) in a IPL auction is 6 crore.This will be the spot price for Dhoni. Now assume there is a series in Newzealand and South Africa before the IPL begins.Now the team owners make a prediction that when Dhoni plays on such true pitches he loses his form and he would be in pathetic form before IPL. Hence his forward price would be less than 6 crore.So he would not buy Dhoni at 6 crore, but rather he will be willing to pay a price of less than 6 crore. And forward contract is just a promise to buy in the future and upfront payment is not made.
Why would somebody want to sell under a price less than the current price? Because you’ll not be able to sell everything in the spot market as in the case of a farmer..

Generally forward price = S*e^rt

This is nothing but the compound interest formula which we studied in our 6th class. This version of the formulae indicates that forward price should quote at a compounded value of the spot rate at the risk free interest rate (This does not take the market conditions I spoke about)
Futures is similar to forward, the only difference being it takes place with a lot of regulation and intermediation..Forward transactions will normally happen for avoiding a risk, but generally futures transaction will be on speculation (Of course, I have made a lot of over simplifying statements here!!)


Options:

I was looking for a house for rent when I was in Bangalore. I found a house through a broker for a rent of 8000 per month. I liked the house very much and the rent was also at very much affordable levels.But we wanted to search other houses as well.
Hence we didn’t want to shift to the new home immediately..We wanted to take a chance. We wanted to delay the option of shifting, as well as we wanted to have the option of getting into the new home. As the prices in Bangalore were skyrocketing at that period(hypothetical) , if we were to come three months later the rent would have been double what we had to pay currently . Hence we devised a strategy..We said to the owner that we’ll pay three months of token advance immediately and will occupy the home after three month at the current rent. Now the house owner (who had an exactly opposite view of ours) thought that prices will fall in the next three months , immediately agreed to our strategy and got the three months advance from us…
Now we had the right to take the rental option three months down the line at the current price. But luckily all four of us got into top rung B-schools and hence we didn’t need the house anymore. Hence we didn’t have to use our right and hence we lost our 3 months advance ….
This is all about options... Two parties have differing view about market..One perceives the market to go up and the other perceives it to go down.Both of them think the other person to be a fool. The person who takes the risk is called the option writer and he gets an income for taking the risk..The risk for him (in our case the house owner) is that the rentals can skyrocket in the next three months but he is bound to give it at a much lesser price for us. So in order to have that option we gave the advance, which in financial parlance is called as option premium.
As we saw with the above example, we four had the right to buy something …This option is called as a call option.Exactly opposite to this is an option to sell which is called as a put option.

PS:I would have ideally liked to cover swap also through this article, but I generally try to restrict my posts to less than 1000 words. I promise you a post on swap in the forthcoming days…
PPS: There have been quite a lot of simplifying assumptions behind my example...These are just for illustrative purposes and might slightly deviate from the actual technicalities involved in the concept. Hence I would request the financial purists to resist from quoting comments on my examples.

Strategy vs. Chess

Chess is the only game I have played in my life seriously and I was a national level player in chess. In case if some of you have been deceived by the fact that I often quote lot of things from cricket, I confess at this point that I have not played cricket at the competitive level :)
This article is an attempt to compare some of the concepts in chess to strategy in business..Let’s see whether it works..


Don’t Channelize your resources to your weakest area: In chess every piece is important..Losing a single extra pawn can cause a lot of difference at the competitive level..Hence while playing chess we would start concentrating on every single piece. A lot of times a particular pawn(Soldier) will be under threat and in order to safeguard that pawn three of your major pieces(rook , queen) will be put as guard…It gives the opponent to time to develop his pieces , it gives him time to settle down..Precisely the same thing happens in business..When companies start channelizing their resources towards their weakest area, you tend to lose out on other areas..Your obvious question would be ‘how will a company overlook such a simple thing..’..But the sad reality is that the companies believe they can turnaround a failing business , the top management has a strong ego(they want to be number one in every field) which makes them invest in a activity which would reduce the shareholder value . I was recently reading the book by Mckinsey on Valuation...They gave an example of restructuring activity wherein they divested a business just because of the sudden realization of the fact that this particular business was eating away their productive resources and not earning according to the expectations of the shareholders.


Counter attack: This has become a cliché term amongst the management students!! ..I remember my own game in a state level tournament where I was playing against the most fancied player..I was playing the traditional game of chess developing all my minor pieces, doing a castling and then taking the game forward to the middle game...My opponent suddenly attacked me on my king side and in the process his king was exposed in the middle. Now I had two options: one was to get back and defend my king side..For this all my pieces have to rush to the safety of the king...The other obvious choice was to attack his king , which would take him by surprise. I went for the counter attack and finally won the battle..Relating this to business scenario , when your opponent attacks you , if you get onto a defense then its advantage – opponent ,because he would have clearly anticipated your move and he would be ready with his next move as well….Instead counter attack..In case the competitor starts a price war in your premium product, then take him by surprise by launching a new product which would compete in the middle segment..Since he would not have anticipated a counter attack its advantage – You..



Play to your strength : It’s a known fact that Vishwanthan Anand is one of the greatest player in Sicilian defense opening and Kasparov generally plays a Queens gambit(which is a attacking game)…Now Anand always plays according to his strength rather than falling to opponents strengths..A direct mapping can be done to the business environment..In case you skill is in manufacturing then do only that activity …outsource other activities...Just because your competitor is vertically integrated, you don’t have to do activities where you don’t have strength..We read recently about TCL electronics in a case study where I understood they had a clear vision that they should be the number one TV producer..They were also competing to become the market leader and they were also earning good revenues in the market but they limited their vision to be the number one ‘producer’...This was because they knew clearly they didn’t have any strength in marketing or distribution or even in R and D activity..They were good only in manufacturing..They played to their strength and did well in the market..Expanded to different nations...Had a tie up with firms which gave them the complementary skills…This is strategy for you!!


Look for that loose bricks: When my strategy prof told me this, I immediately remembered my chess masters analogy ‘Whenever you need to break a dam, you’ll start striking on the weak point’..So he always insisted me to look for that weak spot…Our first case on strategy was on Wal-Mart competing against K-Mart and becoming the market leader...In fact Wal-Mart did not play heads on with K-Mart..But they searched for those loose bricks...They set up the stores in small cities ignored by K-Mart..They did not spend too much on advertising unlike other competitors and hence was able to sell at a cheaper price…So they found such loose bricks and capitalized on it and became a giant…

Hope you enjoyed reading the article….