Principles of Valuation: Risk and Return

Start Date: 02/10/2019

Course Type: Common Course

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About Course

This second course in the specialization will last six weeks and will focus on the second main building block of financial analysis and valuation: risk. The notion of risk and statistics are intimately related and we will spend a fair amount of time on the development of some statistical concepts and tools, namely distribution theory and regression analysis. This time will be well spent because these concepts and tools are also commonly used in many applications in the real world. The foundational idea of diversification will then be used to develop a framework for evaluating risk and establishing a relationship between risk and return. Apart from developing a keen appreciation of risk for making thoughtful decisions in an institutional context, this course will contain a lot of material and examples that will enable the learner to make smart personal investing decisions. The course will again have time included for assimilation and two final exams. This course is the second in a sequence of four courses that comprise a Specialization on Valuation & Investing.

Course Syllabus

This module contains detailed videos and syllabi of both the Specialization and this course. This specialization has been designed to enable you to learn and apply the powerful tools of modern finance to both personal and professional situations. The courses within progress linearly and build on each other and it is important for you to get an understanding of why this specialization may be relevant to your goals, again both personal and professional. Please review the videos and syllabi as they will give you a sense of the specialization and how this specific course fits within. The teaching style and philosophy of the instructors is also presented to you (hopefully) in sufficient detail. Most importantly, it will give you enough information for you to make a decision about whether you want to take this course, by itself or as part of a specialization.

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Course Introduction

This second course in the specialization will last six weeks and will focus on the second main build

Course Tag

Stock Bond Valuation Finance Stock Valuation

Related Wiki Topic

Article Example
Valuation risk Valuation risk is the financial risk that an asset is overvalued and is worth less than expected when it matures or is sold. Factors contributing to valuation risk can include incomplete data, market instability, financial modeling uncertainties and poor data analysis by the people responsible for determining the value of the asset. This risk can be a concern for investors, lenders, financial regulators and other people involved in the financial markets. Overvalued assets can create losses for their owners and lead to reputational risks; potentially impacting credit ratings, funding costs and the management structures of financial institutions.
Valuation risk Valuation risks result from data management issues such as: Accuracy, integrity and consistency of static data. Accuracy and timeliness of information such as corporate events, credit events, or news potentially impact them. Streaming data, such as prices, rates, volatilities are even more vulnerable as they also depend on IT infrastructure and tools therefore adding a notion of technical and connectivity risk.
Riskreturn spectrum The riskreturn spectrum (also called the riskreturn tradeoff or risk–reward) is the relationship between the amount of return gained on an investment and the amount of risk undertaken in that investment. The more return sought, the more risk that must be undertaken.
Valuation risk In addition, an important aspect of managing valuation risk is associated with model risk. In search of transparency, market participants tend to adopt multiple model approaches and rely on consensus rather than science. In the absence of deep and liquid market transactions, and given the highly non-linear nature of some of the structured products, the mark-to-model process itself requires transparency. To achieve this, open pricing platforms may be linked to the centralised data warehouse. Those platforms are capable of using multiple models, scenarios, data sets with various distribution and dispersion models to price and re-price under ever-changing assumptions.
Valuation risk The shock wave which affected the credit and capital markets following the burst of the US sub-prime mortgage crisis in late 2007, tested most underlying assumptions and had sweeping effects on a number of models that would unlikely be calibrated for extreme market conditions, or tail risk. This led to an emergency call for transparency and assessments of exposure from the financial institutions’ clients, shareholders and managers, echoed by the regulators. In this process, it appears that market exposure and credit exposure intricately mix into a single notion of valuation risk.
Valuation risk The final aspect of managing valuation risks relates to the actions that can be taken within the firm as a result of the assessments of exposures and sensitivities reported. The management of tail risks should also be reviewed so that allocating economic capital weighted by a very low probability of occurrence of an event amounted to considering a normal distribution of events or simply overlooking the tail risk.
Riskreturn spectrum If an investment had a high return with low risk, eventually everyone would want to invest there. That action would drive down the actual rate of return achieved, until it reached the rate of return the market deems commensurate with the level of risk. Similarly, if an investment had a low return with high risk, all the present investors would want to leave that investment, which would then increase the actual return until again it reached the rate of return the market deems commensurate with the level of risk. That part of total returns which sets this appropriate level is called the risk premium.
Risk return ratio The Risk-Return-Ratio is a measure of return in terms of risk for a specific time period. The percentage return (R) for the time period is measured in a straightforward way:
International Valuation Standards Council The IVS Framework includes generally accepted valuation concepts, principles and definitions upon which the International Valuation Standards are based. This framework should be considered and applied when following the individual standards and valuation applications.
Valuation risk Valuation risks concern each stage of the transaction processing and investment management chain. From front office, to back office, distribution, asset management, private wealth and advisory services. This is particularly true for assets that have low liquidity and are not easily tradable in public exchanges. Moreover, issues associated with valuation risks go beyond the firm itself. With straight through processing and algorithmic trading, data and valuations must remain synchronized among the participants of the trade processing chain. The executing venue, prime brokers, custodian banks, fund administrators, transfer agents and audit share files electronically and try to automate such processes, raising potential risks related to data management and valuations.
Risk-adjusted return on capital Risk-adjusted return on capital (RAROC) is a risk-based profitability measurement framework for analysing risk-adjusted financial performance and providing a consistent view of profitability across businesses. The concept was developed by Bankers Trust and principal designer Dan Borge in the late 1970s. Note, however, that more and more return on risk adjusted capital (RORAC) is used as a measure, whereby the risk adjustment of Capital is based on the capital adequacy guidelines as outlined by the Basel Committee, currently Basel III.
Risk return ratio The Risk-Return-Ratio is then defined and measured, for a specific time period, as:
Riskreturn spectrum A commercial property that the investor rents out is comparable in risk or return to a low-investment grade. Industrial property has higher risk and returns, followed by residential (with the possible exception of the investor's own home).
Risk (magazine) financial coverage includes operational risk, accounting, FRTB, structured products, valuation adjustments, electronic trading, clearing, interest rate risk, energy, oil, gas, power, MIFID, liquidity risk and solvency II.
Riskreturn spectrum All this can be visualised by plotting expected return on the vertical axis against risk (represented by standard deviation upon that expected return) on the horizontal axis. This line starts at the risk-free rate and rises as risk rises. The line will tend to be straight, and will be straight at equilibrium - see discussion below on domination.
Risk-adjusted return on capital Broadly speaking, in business enterprises, risk is traded off against benefit. RAROC is defined as the ratio of risk adjusted return to economic capital. The economic capital is the amount of money which is needed to secure the survival in a worst-case scenario, it is a buffer against unexpected shocks in market values. Economic capital is a function of market risk, credit risk, and operational risk, and is often calculated by VaR. This use of capital based on risk improves the capital allocation across different functional areas of banks, insurance companies, or any business in which capital is placed at risk for an expected return above the risk-free rate.
Riskreturn spectrum On the lowest end is short-dated loans to government and government-guaranteed entities (usually semi-independent government departments). The lowest of all is the risk-free rate of return. The risk-free rate has zero risk (most modern major governments will inflate and monetise their debts rather than default upon them), but the return is positive because there is still both the time-preference and inflation premium components of minimum expected rates of return that must be met or exceeded if the funding is to be forthcoming from providers. The risk-free rate is commonly approximated by the return paid upon 30-day or their equivalent, but in reality that rate has more to do with the monetary policy of that country's central bank than the market supply conditions for credit.
Principles of Corporate Finance The book covers a wide range of aspects relevant to corporate finance, illustrated by examples and case studies. The text starts with explaining basic finance concepts of value, risk, and other principles. Then the issues become more and more complex, from project analysis and net present value calculations, to debt policy and option valuation. Other discussed topics include mergers and acquisitions, principal–agent problems, credit risk, working capital management, etc. The book concludes with a discussion on the current limitations of the corporate finance theory.
Sociology of valuation The sociology of valuation (sometimes "valuation studies") is an emerging area focusing on the tools, models, processes, politics, cultural differences and other inputs and outcomes of valuation.
Art valuation Art valuation, an art-specific subset of financial valuation, is the process of estimating the potential market value of works of art and as such is more of a financial rather than an aesthetic concern, however, subjective views of cultural value play a part as well. Art valuation involves comparing data from multiple sources such as art auction houses, private and corporate collectors, curators, art dealer activities, gallerists (gallery owners), experienced consultants, and specialized market analysts to arrive at a value. Art valuation is accomplished not only for collection, investment, divestment, and financing purposes, but as part of estate valuations, for charitable contributions, for tax planning, insurance, and loan collateral purposes. This article deals with the valuation of works of fine art, especially contemporary art, at the top end of the international market, but similar principles apply to the valuation of less expensive art and antiques.