Exploring portfolio risk in financial management involves understanding the potential for loss in an investment portfolio. It encompasses systematic risk, which affects the entire market, and unsystematic risk, specific to individual assets, which can be mitigated through diversification. The text delves into quantifying risk using statistical measures, employing models like VaR and CAPM, and implementing risk management strategies through asset allocation and hedging. Regular risk analysis is emphasized for maintaining a balance between risk and reward.
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Portfolio risk is divided into two main categories: systematic risk and unsystematic risk
Importance of Diversification
Diversification is a crucial technique for reducing unsystematic risk and protecting the portfolio against the volatility of individual investments
Practice of Diversification
Diversification involves spreading investments across various asset classes and sectors
Portfolio risk is measured through statistical measures and models such as volatility, correlation, and the Expected Portfolio Return formula
The VaR model estimates the maximum loss expected over a given time period at a certain confidence level
The ES model calculates the average loss that could occur beyond the VaR threshold
Capital Asset Pricing Model (CAPM)
The CAPM decomposes asset returns into fundamental risk factors to manage systematic risk
Arbitrage Pricing Theory (APT)
The APT also decomposes asset returns into risk factors to manage systematic risk
Asset allocation is the process of deciding the proportionate distribution of investments across different asset classes
Hedging involves taking offsetting positions in related securities to manage risk
Insurance products can be used to transfer risk
The goal of risk management is to achieve an optimal balance between risk and return
The portfolio risk analysis process starts with defining investment goals
The process involves identifying the types of risks present in the portfolio
Statistical techniques are used to measure risk levels
The results of the analysis are interpreted through various metrics such as total risk, Sharpe Ratio, and distribution of returns
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Meaning of Portfolio Risk
Potential for loss in a collection of financial assets; variability of returns.
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Role of Portfolio Risk in Financial Planning
Influences strategic decisions; helps in assessing potential losses and gains.
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Diversification Purpose
Spreads investments to reduce unsystematic risk; protects against volatility.
