Independent Research

A Paper on Market
Risk Measurement
& its Management

Prepared by

SIVARAJA
RAMASWAMY
DECEMBER - 2003

MEASURING & MANAGING PORTFOLIO (MARKET) RISK

Introduction
Risk management: As easy as crossing the street
The cornerstone of successful and repeatable investment strategies is risk management.
While many individuals are scared off by financial risk management, by the complexity
of the math or the negative connotations, the management of risk is really a skill we are
all taught as children. Look both ways before crossing the street and Dont take money
from strangers are good risk management techniques. While the returns are clear, we are
all told to consider the risk first. Financial risk management is no different. While the
numbers can be complex, they are only an input into a sound investment strategy. The
most crucial element of managing risk is not the use of mathematics, but the use of good
common sense, the same common sense that, has been instilled in you as a child. History
has shown us on countless situations where the markets did the unexpected.
Professionals know that active risk management is the best way to deal with this
uncertainty and to produce superior returns. In the following pages we will delve
elaborately into risk management in the context of making better investment decisions.
The next few pages contain certain basic information about risk and risk management.

1. Risk: A definition and discussion of risk applied to the financial markets.

2. Importance of risk: Arguments for including risk measures in a return-focused
community.
3. Risk Measurement.: Available measures for assessing risk associated with a
financial investment.
4. Portfolio Risk Calculation.: Understanding how a portfolio Risk calculation enables
you to manage your expectations.

1 Risk
Definition of risk
Simply put, risk is uncertainty. In the financial world, risk is often measured in terms of
volatility (or variability) of returns. For example, given that in 2002 the daily variability
of returns for the MSM Index and Bank Muscat shares were 0.465% and 1.631%
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respectively, we can venture that Bank Muscat was a riskier investment than the MSM
Index. ( though no option is available to the investors for investing in the MSM Index as
of date ) In fact, Bank Muscats returns were about three and a half times (or precisely
1.631/0.465) as volatile as returns of the MSM Index. But if Bank Muscat was four times
riskier, why did it outperform the MSM by 329%? Thats because risk cuts both ways.
Investing in Bank Muscat stock means that you are more likely to experience sudden
large drops in value, but you also stand a chance to make a higher return. Compare Bank
Muscats biggest daily drop and gain (-5.19% and +9.85%) against the MSM Index
(-1.28% and +2.98%) in the table below. Higher volatility means the possibility of larger
losses and larger gains. You can see the same pattern when you look at other shares listed
in MSM too.
As risk relates to the chance of losing or making money, it becomes clear that risk is not
necessarily a bad thing. In fact, risk can hold tremendous opportunities for those who
know how to manage it. Those who cant stomach risks are guaranteed to miss out on
promising opportunities. For example, those who keep all their financial assets under
their mattress lose in the long run when inflation erodes their purchasing power. For
example, assuming 5% inflation, RO100 under your mattress loses 40.13% of your
purchasing power over 10 years. The old adage nothing ventured, nothing gained
could actually be nothing ventured, sure to lose. "If no one ever took risks,
Michelangelo would have painted the Sistine floor." - Neil Simon
Risk and time:
Risk is different for every person. First, different people have different investment time
horizons. The first question to ask when making an investment is When do I need the
money? A good investment for a 26 year old is probably not a good investment for a 62
year old. If youre likely to need your money within five years, you should not invest
your entire wealth in high-risk assets. On the other hand, if your investment horizon is
long (10 to 20 years), you should be more willing to accept the short-term fluctuations of
risky securities in exchange for long-term growth prospects. In general, you can accept
more risk the longer you can put off touching your money, because you have more time
to recoup potential losses along the way.
Risk and Objectives
Second, different people have different objectives. Are the returns of your financial assets
necessary for you to make your mortgage payments. This will have a significant
influence in how much risk you should tolerate in your portfolio. Likewise some
investors have absolute return goals (e.g., 10% annual return) while others have relative
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return objectives (e.g., outperform the S&P 500 index by 1% per annum or the MSM
Index by 5% per annum). This will influence whether you should consider your risk
against an absolute level or relative to a benchmark It is crucial however to have clearly
defined objectives to be successful in managing the risk of your investments. All too
often, people set one objective (i.e., Ill buy this stock for a quick trade) and when the
markets do not move as expected, they change that objective (Ill make it part of my
long-term portfolio). Look at the following example, where an investor had put in
money into the stock market to quickly make a few Rials to buy a new car, and when the
market went down, he decided he needed the investment in his retirement plan. A
disciplined and consistent investment strategy is required for the successful management
of risk.
Risk as opportunity
As the proverbial mattress stuffer demonstrates, we cant expect to get anywhere if
we avoid taking risks. History shows that great accomplishments have always involved
taking significant calculated risks. Great deeds are usually wrought at great risks,
noted Greek historian Herodotus. Great artists, investors, and entrepreneurs alike are
willing to take risk because they see it as opportunity. Rather than avoid risk entirely, we
should avoid taking poorly understood risks and instead choose to take risks where the
potential upside justifies the potential downside. The ability to understand, measure and
manage risk can empower all people to make better decisions. Whats your risk
preference? So whats the right amount of risk to take? First, consider your risk
preference. After all, what good is a profitable investment if it costs a heart attack along
the way? One person may be inherently comfortable with risks that make anothers
stomach churn. How would you feel if your portfolio lost 10% or even 21% in a single
day (thats how much the NASDAQ fell by as recently as April 14, 2000 and the S&P
500 fell by on Black Monday in October 87)

2. Importance of risk
The world is return-focused
Historically, most investors have focused on returns, while neglecting how much risk was
taken to generate those returns. Return information is ubiquitous in newspapers, Internet
sites, and financial statements, while risk information is difficult to come by. Every
month / quarter, investors see popular magazine rankings of the highest returning shares
with the implicit assumption that these were the best performing Corporate companies.
However, in order to judge investment performance, we must understand how much risk
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was taken to generate the returns. You may be surprised to find that the highest
performing shares change radically from year to year, while the list of the most risky is
remarkably consistent. In fact the one conclusion that you can draw from a list of the best
absolute performing shares in any one year, is that they may not be the best performing
shares the following year.
Quantify risk as you currently quantify return
In addition to better verbal risk disclosures, investors should receive more quantitative
risk information. While mutual funds provide precise return numbers, most risk
disclosures are still vague and general (e.g., the funds holdings present aggressive,
balanced, or moderate risk) Risk should be quantified as rigorously as returns. For
example, how would you feel if your mutual fund ( or for that matter entities who
manage your private equity investment submit periodical performance report )
statements reported that last quarters returns were balanced, or moderate instead of
stating the return number? Risk information is as important as Net Asset Value (NAV)
and returns, and should be updated and accessible on a daily / weekly / monthly / semiannual basis. The idea behind this exercise is to provide individual investors with risk
information for all traded shares in the MSM. Factor risk into decision making. We pay a
great deal of attention to risk in our personal life, but often make financial decisions
without the appropriate understanding of risk. We look both ways before we cross the
road. We research a companys prospects before we accept a job offer. We buy health,
auto, life and homeowners insurance. Imagine living your personal life without
considering risk: Would you trust an unmarked car to give you a ride from a foreign
airport? Would you go on a dangerous expedition with a novice guide? Would you plan a
family picnic without checking the weather forecast? We need to apply the same risk
management discipline to financial decisions as we apply to the rest of our lives. We
cant make investment decisions without looking at risk.

3. Risk Measurement:
Measuring risk
Risk measurement is based on a historical analysis of returns. Rather than predict which
way the market moves (e.g., whether the MSM Index moves up or down next month), we
forecast how large the market movements are likely to be (e.g., what is the chance of the
MSM Index moving by more than 10% next month). Risk estimates are much more
stable and reliable than directional forecasts, and given a reasonable history of market
returns, we can achieve high-confidence risk estimates (generally 95%, or even 99%
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confidence). The basic idea behind this small write up about risk is to make you a better
investor by providing you with the knowledge, tools and data to make better decisions.
Introducing Risk Measurements.
Risk Measurement is a statistic, a measure of return variability adopted / devised by
many bigger financial service providers to help investors better understand their market
risk. Risk Measurements are generally scaled from 0 to values exceeding 1000, where
100 corresponds to the average Risk level of a diversified (market-cap weighted) index of
international equities during normal market conditions. The average risk level of the
diversified global portfolio of 100 corresponds to a standard deviation of 20% per annum.
You would expect cash to have a Risk level of 0, while a technology IPO may have a
Risk level closer to 1000. Risk levels are dynamic - changing over time to accurately
reflect market conditions, allowing for comparisons in an intuitive fashion, and capturing
other forms of risk too such as currency risk.
Risk levels vary over time
Risk level is dynamic and adjusts to current market conditions during turbulent times,
such as the Asian Crisis or the Russian Devaluation. The Risk levels of major stock
markets can easily escalate beyond 200, ( standard deviation of 40% per annum ) while in
calmer markets Risk levels could fall below 75 ( standard deviation of 15% per annum )

4. Portfolio Risk Levels:

The following table shows the Risk levels for five MSM stocks, two US based mutual
funds and the MSM Index. Does anything strike you as odd?
Stock/Index Risk levels:
1.
2.
3.
4.
5.
6.
7.
8.

Oman International Bank

National Bank of Oman
Bank Dhofar Al Omani Al Fransi
Alliance Housing Bank
Bank Muscat
AIM Advisor, Large Cap Value Fund - Class A Shares
Dreyfus Index Funds Inc., S&P 500 Index Fund
MSM Index

-145
-199
- 99
-136
-172
-152
-127
-105

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MEASURING & MANAGING PORTFOLIO (MARKET) RISK

At first glance you may ask why the Risk level for an individual stock is generally larger
than the Risk level of its equity index or a fund composed of similar stocks (for example,
in the above table, NBO is 2 times more riskier than the MSM Index). This is the power
of diversification. We will get to the power of diversification shortly. But first we should
remember that the goal is to make better investment decisions. For that we need several
risk measures, just as we use several return measures. The tools we provide for measuring
risk on the portfolio level are: a portfolios systematic risk and unique risk. It is with this
combination of risk measures that an individual can begin to optimize his or her
investment portfolio.

Diversification:
The Sum of the Parts DOES NOT Equal the Whole. A time-tested risk management
technique and common approach practiced by professional money managers to minimize
the ups and downs of a portfolio, is diversification. An easy way to think about
diversification is that on any given day, not every stock traded on an exchange will go up
or down together. When stocks of a specific company type go up or down independent
from the greater market, this is known as sector diversification. The technology stocks
are down, but the utilities are up. You can then extend this argument further. The Muscat
Securities Market may go down today, driven by local concerns. However, Saudi
Arabias stock market may rise. This type of diversification is known as geographic
diversification. We can also throw another layer of diversification into the mix - asset
class diversification. Simply stated, asset class diversification assumes that stocks and
bonds may not both go up or both go down on any one given day. Using all these
different types of diversification, geographic region with asset class, sector within asset
class, and so on, you will get what professionals consider a well-balanced portfolio. A
little confused by all this? Remember the famous adage, dont put all your eggs in one
basket. Diversification is just good old common sense.

Diversification Efficiency
In the absence of diversification, the risk of a portfolio should equal the weighted sum of
the risks of the securities in the portfolio just as the expected return of the portfolio equals
the weighted sum of the expected return of the securities. Therefore, the effect of
diversification may be measured by comparing the risk of the portfolio and the weighted
average of the risk of the securities. The weighted average of the standard deviation of
OIB, NBO, BDOF, Alliance and Bank Muscat from the example above is 0.2(0.0836) +
0.1(0.1151) + .25(0.0574) + .25(0.0787) + .2(0.0991) = 0.0821. The standard deviation of
the portfolio is 0.0498. Since the portfolio standard deviation is less than the weighted
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average of the standard deviation of the securities, diversification has indeed been
achieved.
The greater the difference between the portfolio standard deviation and the weighted
average of the standard deviations of the securities, the better the diversification. The
ratio created by dividing this difference by the weighted average of standard deviation of
securities tells us the fraction of the risk that has been diversified away. In absence of
diversification, portfolio of OIB, NBO, BDOF, Alliance and Bank Muscat would have
had a standard deviation of 0.0821. The portfolio, due to diversification, has a standard
deviation of 0.0498. Therefore, (0.0821 0.0498) / 0.0821 = 0.3934 or 39.34% of the risk
has been diversified away.
A risk level of 124 for the portfolio as a whole is less than the risk level of each of the
above individual stocks ( except BDOF ). The diversification measure calculated for this
portfolio is 61. In essence it means that the effects of diversification is making the above
portfolio 39% less risky. Hence in a portfolio the sum of individual stocks risk levels do
not equal the whole.

It is assumed that this short note has given an overview of how understanding risk can
help you make better investment decisions. The intent of this note is to educate, not
overwhelm, so that you, as an individual investor, can benefit from some of the same
tools that professionals use in managing money. As each of us take on more
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responsibility for our own financial future, it is crucial that we have as much help as
possible in guiding our investment strategies. At this point it is hoped that it is clear how
the mass proliferation of real-time price and return information, fancy charts, and
technical analysis should be supplemented by some basic risk measures as discussed
above. And remember, no matter what you do, Return is Only Half the Equation.

Risk calculation methodology for a portfolio of shares held in MSM:

In this worked example, assume that we have a portfolio consisting of only the five
companies listed in the table below which are held in the given investment proportions.
S.No
1
2
3
4
5

Shares
OIB
NBO
BDOF
Alliance
Bank Muscat

Sector
Banking
Banking
Banking
Banking
Banking

R2
0.5641
0.6661
0.1709
0.3577
0.5882

Proportion
0.20
0.10
0.25
0.25
0.20

Beta
1.1350
1.4377
0.3820
0.8915
1.9928

Std Devn
8.36%
11.51%
5.74%
7.87%
9.91%

In order to conduct a risk analysis on this portfolio we will want to calculate its beta,
unique risk and total risk.

Calculating the Market Risk, Unique Risk, Total Risk, Abnormal

Return and Risk Interpretation of the above portfolio
_____________________________________________________________
Calculation of the Portfolios Market Risk:
Recalling that the Beta of a portfolio is simply the weighted average of the component
Betas of the portfolio and can be calculated as follows:
S No
1
2
3
4
5

Shares
OIB
NBO
BDOF
Alliance
Bank Muscat

Proportion
0.20
0.10
0.25
0.25
0.20

Beta
Proportion x Beta
1.1350
0.2270
1.4377
0.1438
0.3820
0.0955
0.8915
0.2229
1.9928
0.3986
Portfolio Beta
1.0878

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Hence we can on an average expect this portfolio to move 10.88% for every 10% move
of the MSM market index.
We can also compute the magnitude of market risk of the portfolio. In order to do this we
need the standard deviation of the market index. We find that the standard deviation of
the MSM market index is 6.07% per month in the last 60 months period. ( from October1998 till September-2003 )
The market risk of the above portfolio = Portfolios Beta x Market risk of the index
= 1.0878 x 6.07
= 6.60% per month

Calculation of the Portfolios Unique Risk:

Calculating the magnitude of the above portfolios unique risk is a little trickier than
calculating the unique risk of an individual share. Let us begin by calculating the unique
risk of the constituent shares in the above portfolio.
There is a special relationship that links the different kinds of risk:

It is important to realize that we can add the square of the standard deviations (i.e. the
variances) but we cannot add the standard deviations and still obtain a meaningful
interpretation.
Market Risk is also known as Systematic Risk or Non-Diversifiable Risk and Unique
Risk is known as Un-Systematic Risk or Diversifiable Risk or Firm Specific Risk or
Residual Risk or Idiosyncratic Risk.
Since R ( Co-variance between the Securitys return & MSMs return divided by the
product of the Standard deviations of the Securitys return & MSMs return ) is the
proportion of market risk relative to total risk and 1-R is the proportion of unique risk
relative to total risk, we can express the above relationship as:

It is easy to see that the components of risk can be obtained by comparison of the above
expression:
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________________________

Unique Risk = (1-R2) (Total Risk)2

Similarly

___________________

Market Risk = R2 (Total Risk)2

Note that we do not have information concerning the R and the total risk of the portfolio
as a whole and so we cannot directly compute these risk components for the above
portfolio using the above expressions. We do however have all the necessary information
to compute these two risk components ( market risk and unique risk ) for individual
shares in the above sample portfolio.
Recalling that the standard deviation of an individual share is the absolute measure of its
total risk for the share. We can thus calculate the magnitude of the two components of
risk for individual shares using the above expressions as follows:

S.No
1
2
3
4
5

Shares
OIB
NBO
BDOF
Alliance
Bank Muscat

R2

1 - R2
0.5641
0.6661
0.1709
0.3577
0.5882

0.4359
0.3339
0.8291
0.6423
0.4118

(Std Devn)2
69.8896
132.4801
32.9476
61.9369
98.2081

Mkt
Unique
Risk (%) Risk (%)
6.2789
5.5195
9.3939
6.6509
2.3729
5.2266
4.7069
6.3073
7.6004
6.3594

We could also have obtained the market risk for each share by simply multiplying the
Beta value of the shares by the market risk as we did when we calculated the magnitude
of the portfolios market risk. However there will be a marginal difference between the
market risk worked out by this process and the one worked out as above because of the
adjustments and error corrections.
The calculation of the unique risk of our portfolio is shown below. Here we multiply the
investment proportion by the unique risk, square and then sum across the constituent
shares. Finally we take the square root of the result to obtain the portfolio's unique risk.

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S No
1
2
3
4
5

Shares
OIB
NBO
BDOF
Alliance
Bank Muscat
Total

Proportion Unique Risk (Proportion x Unique Risk)2

0.20
5.5195
1.2186
0.10
6.6509
0.4423
0.25
5.2266
1.7073
0.25
6.3073
2.4864
0.20
6.3594
1.6176
7.4722

Portfolios Unique Risk = 7.4722 = 2.7335% per month

Note how effectively the unique risk has been reduced. By diversifying amongst the
above shares we find that the unique risk of the portfolio is substantially less than the
unique risk of most of the individual shares. The above calculations assume that the
constituent shares are not all lumped in one industry. ( whereas they are lumped together
infact ) If all constituent shares are lumped in one industry then the actual unique risk
may be slightly higher than that calculated using the above method.
---------------------------------------------------------------------------------------------------------------------------------

Calculation of the Portfolios Total Risk:

Recalling that:

This relationship is true both for individual shares as well as for portfolios, hence:
(Portfolios Total Risk) = (6.60) + (2.73) = 51.03
and so
Portfolios Total Risk = 51.03 = 7.1435%
We are now able to compute the portfolios proportion of market risk and its proportion
of unique risk. Statistically, the portfolio has:
R2 = (6.60)2 / (51.03) = 0.8536
and (1-R) = 0.1464
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That is, 85% of the portfolios movements can be explained by movements in the MSM
market index while the remaining 15% of the portfolios movements can be explained by
unique factors specific to the sector/industry. There is clearly scope to improve the
diversification benefits (i.e. reduce the risk) of the portfolio. A well diversified portfolio
would have a unique risk component which accounts for 5% or less of the portfolios
total risk.

Calculation of the Portfolios Abnormal Return:

The abnormal return is equal to the difference between the actual return of our portfolio
and the return realized from a benchmark portfolio with precisely the same market risk as
our own portfolio.
Since the above sample portfolio has a Beta of 1.0878, this implies that the benchmark
portfolio also has the same market risk and therefore the amount which needs to be
invested in the benchmark portfolio is 108.78% of our initial funds invested in the sample
portfolio of shares. The market index shows a return of 42.12% for the 12 months period
Jan-2003 till Dec-2003.
Benchmark Portfolios Return = Beta x Market Index Return
= 1.0878 x 42.12% = 45.82%
To calculate the actual return on the our portfolio, we simply sum the returns over the
same period ( as that of the MSM Index for the period Jan-2003 till Dec-2003 ) of the
constituent securities, weighted by their investment proportions. In the calculation of
abnormal return that follows, the time periods for the benchmark return and the actual
returns must clearly match one another.
Actual portfolio return calculated for the above period in respect of the 5 shares in
respective proportions mentioned elsewhere in this paper is 54.24%
Abnormal Return = Actual Return - Benchmark Return
= 54.24% - 45.82%
= 8.42% p.a
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(We can calculate the abnormal return for an individual security in precisely the same
way, again using the notion of benchmark portfolio return)
Although the market risk of the above portfolio is identical to that of the benchmark
portfolio, the portfolio has a unique risk of 2.73% per month while the benchmark
portfolio has none. Our previous discussion reminds us that there is no automatic reward
for taking on unique risk. So unless you had special knowledge about your shares, an
abnormal return of 8.42% per annum is more likely to occur in, on average, two out of
every 5 years.
We can also use the notion of a benchmark return to give us some idea of how our
portfolio is expected to perform in the future. For example, assume we are interested in
our portfolios expected performance in the forthcoming year. This of course depends on
the performance of the market to a large extent. We may have some prediction of our
own of the market performance. If not, we can use past experience as a guide. Based on
the last 14 years track record on the MSM, a return on the market index of 17% over and
above the risk-free interest rate ( 6% to 9% ) seems a reasonable expectation. Adding an
interest rate of 8% to this figure suggests an expected return on the market of 17% + 8%
or 25% per annum. Hence the expected return on our portfolio is:
Expected Return = Beta x Expected Market Return
= 1.0878 (25%)
= 27.20%
The difference between the actual realized return and the expected return calculated as
above represents Jensens Alpha, a measure used to evaluate the performance of an
investment portfolio. Here in our case the Jensens Alpha is (54.24% - 45.28%) = 8.96.
Apart from the above ratio, two more measures of performance Sharpe and Treynor
ratios assess the performance of an investment by determining the rate of return earned
per unit of risk. The ratios are calculated as the excess return, the rate of return on
investment minus the risk-free rate of return, divided by the measure of risk. The ratios
differ in how they define risk. The Sharpe ratio uses the standard deviation of returns as
the measure of risk while the Treynor ratio uses beta as a measure of risk. ( on the
assumption that in case of portfolios the unique risk is diversified away and only the
systematic risk remains to be addressed )
Claims of superior performance are frequently made by mutual funds to attract investors
to buy shares in their funds. The fund managers often claim that they beat the market in
the past using their timing and selectivity skills. Timing refers to the ability to predict
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which way the market as whole will swing. Selectivity refers to the ability to predict
securities will be superior performers. Studies done by finance academics find little
evidence for superior performance by mutual funds or their managers on an average.
Most studies find that the timing ability of the fund managers are particularly suspect.
The conclusion most performance measurement studies draw from long term
research/analysis is that the returns an investor earns by investing in mutual funds are in
line with or less than what the investor should have earned based on the risk taken.
Investors therefore should primarily consider and invest in mutual funds for reasons of
diversification and not necessarily for superior performance.

No

Description

OIB

NBO

BDOF

Alliance

Bk Muscat

Closing Price 31/12/2001

1.190

1.330

2.320

0.730

1.800

2
3
4

Closing Price 31/12/2002

Closing Price 31/12/2003
Return for the year 2003

1.540
2.370
53.90%

1.340
2.710
102.24%

2.250
3.000
33.33%

0.880
1.540
75.00%

3.800
4.970
30.79%

5
6

Std Devn annualized(60 mon)

Beta Coefficient

28.97%
1.1350

39.86%
1.4377

19.87%
0.3820

27.25%
0.8915

34.33%
1.9928

Sharpe Ratio

1.65

2.41

1.38

2.53

0.72

Treynor Ratio

0.42

0.67

0.72

0.77

0.12

Jensens Alpha

6.90%

44.31%

13.54%

36.80%

- 47.19%

Information Ratio (ann)

0.083

-0.173

0.266

0.174

0.332

Coefficient of Variation

0.61

0.41

0.73

0.40

1.39

* - Risk free rate has been assumed to be 6% in arriving at the above ratios. This rate refers to
the long term weighted average rate for Bonds issued by CBO, Oman.
The above tabulation reveals that purely based on the realized returns alone NBO takes
the lead and when we factor the amount of risk assumed by respective banks for
achieving the above tabulated returns then Alliance Housing Bank replaces NBO from
the top and takes the lead. However as per Jensen Alpha, NBO ranks better than the other
4 stocks. This is mainly due to the fact that NBO was facing lot of problems in its loan
book quality and was under pressure to provide for the bad debts during 2001 & 2002.
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NBOs share price as on 31.12.2000 was RO 2.920 which is marginally higher than the
price registered by it on 31.12.2003 because of developments related to allotment of
additional equity on private placement basis by the bank to overcome the problems
related to provisioning.
However as per the information ratio Bank Muscat leads the rest. But in absolute terms
the information ratio of 0.332 achieved by Bank Muscat is on the lower side. For a fund
or stock to be a performer the information ratio has to be in the range of 0.5 or above.
( information ratio of 0.5 is good and 0.75 is very good and 1.0 & above is
exceptionally good.)
The information ratio is a measure that seeks to summarize in a single number the meanvariance properties of an active portfolio. The information ratio is the average excess
return per unit of volatility in excess return. It is also known as the alpha-omega ratio.
( here omega refers to the idiosyncratic risk or the residual risk of the security or the
portfolio ) It is also known as the signal to noise ratio in an engineering perspective.
Also known in the names of appraisal ratio and return to variability ratio in
finance. The information ratio is not useful for making decisions about how much to
allocate to a particular asset class or style. The information ratio does not contain any
information on correlations between asset classes and it also does not take into account
the risk tolerance level of the investor(s). The information ratio is most useful for
measuring the skill & performance of an active fund manager against an appropriate
Benchmark. It is arguably the best single measure of the mean-variance characteristics
of an active portfolio. But investors should never rely exclusively on any single measure.
However to compare between stocks it is advisable to look up to the Sharpe or the
Treynor ratios rather than the Information ratio. There is humpty number of instances
wherein the Information ratio was 0.5 & above as against the Sharpe ratio, which was
negative. ( this will be the case when the particular stock looses 5% in average return
over a specific period, the bench mark index loosing 10% or more during the same
period. Though the average return from the stock is negative, when compared to the
bench mark index it is however superior and positive ) This is because the Information
ratio is a tool to be used for comparing the performance of a stock / portfolio against that
of a bench mark index. Information ratio will tell us whether the portfolio or the stock has
performed better than the bench mark index or not and nothing more. Therefore it is
preferable to study the performance of stocks by comparing all the above ratios together
rather than relying upon one ratio heavily.

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Now we can see the above ratios for the portfolio as such.

S.No

Description

Portfolio

MSM

Closing Price / Index 31/12/2002

191.664

2
3
4
5

Closing Price / Index 31/12/2003

Return for the year 2003
Standard Deviation ( 60 months period )
Beta Coefficient

54.24%
25.05%
1.0877

272.670
42.12%
21.03%
1.0000

Sharpe Ratio

2.16

2.00

Treynor Ratio

49.87

42.12%

0.42

8.95%

Information Ratio
Jensens Alpha

It can be seen from the above tabulation that the portfolio ( though consisted of only
banking stocks and that too 5 listed companies in all ) has achieved a better return and
has shown superior performance over the market for the year 2003. However if one
would like to assess the returns realized by investors of various time horizons then we
will come across cases where an investor who holds onto a security for a longer period is
penalized and the one who holds it just for an year or under gets rewarded.
Correlation Coefficient Matrix for the portfolio of 5 banking stocks
1.000000

0.606355

0.210412

0.309882

0.180930

0.606355

1.000000

0.252167

0.409912

0.441457

0.210412

0.252167

1.000000

0.286668

0.046573

0.309882

0.409912

0.286668

1.000000

0.270411

0.180930

0.441457

0.046573

0.270411

1.000000

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No

Co-Variance Matrix - portfolio consisting of the five banking stocks

BANKS

OIB

NBO

BDOF

Alliance

Bk Muscat

OIB

0.006991

0.005835

0.001009

0.002038

0.001220

NBO

0.005835

0.013243

0.001664

0.003711

0.004571

BDOF

0.001009

0.001664

0.003289

0.001293

0.000225

Alliance

0.002038

0.003711

0.001293

0.006187

0.001860

Bk Muscat

0.001220

0.004571

0.000225

0.001860

0.009821

Interpretation of the Risk characteristics of the above Portfolio:

Investors who are concerned with the notion of risk are clearly concerned about the
potential of a shares return to drop unexpectedly. Yet the standard deviation incorporates
both downside risk as well as upside potential. We have already discussed the various
components of risk and have mentioned that unique risk is the component of total risk
which is not explained by market movements. Therefore, when we computed the
abnormal return it was evident that a portfolio having zero unique risk would have an
abnormal return of zero. Any non-zero abnormal returns consequently reflect the unique
risk of a portfolio. ( 8.42% per annum of the abnormal return in our example is due to the
presence of the Unique risk of the portfolio of 2.73% )
In the context of the expected portfolio return computed above, we are concerned about
the variability of our market index forecast as well as factors unique to our portfolio. That
is, our expected return forecast should be interpreted within the framework of the total
risk of a portfolio.
There is a special relationship between the standard deviation and the number of times we
expect returns to exceed the standard deviation. For example assume our portfolio has an
expected return of 24% with a total risk of 6% per month. How do we interpret this?
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Simply, there is approximately a one in four chance that the actual return will be below
expectation by the standard deviation. Similarly however there is an approximately one in
four chance of the actual return being above expectation by the standard deviation. A one
in four chance can also be interpreted as one year in every four years.

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