Downside Risk

Downside Risk Meaning

The downside risk is a statistical measure that calculates the loss in value of the security due to changes in market conditions and is also referred to as the uncertainty that the realized return can be much less than the anticipated results. Put it helps in quantifying the worst-case loss that an investment can lead to if the market changes direction.

Components of Downside Risk

The following are the essential components of a downside risk metric

Downside Risk

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Source: Downside Risk (wallstreetmojo.com)

Downside Risk Formula

There can be many ways to calculate the downside risk. You can use standard deviation, expected shortfall, or value at risk, which has multiple methods like historical simulation, variance-covariance, etc. The aim is to calculate the maximum you can lose based on the sample space (underlying data) for a particular time horizon and confidence interval.

For the variance-covariance method, downside risk (VAR) is calculated as:

VAR = – Z( z- value based on confidence interval) X  Std. deviation

Example of Downside Risk

Let see the simple example to understand it in a better way.

You can download this Downside Risk Excel Template here – Downside Risk Excel Template

Consider the example of a company ABC whose stock is trading at $ 1000. The following table lists the monthly returns for one year.

MonthReturns
Jan-12%
Feb-5%
Mar6%
Apr7%
May3%
Jun-2%
Jul15%
Aug-8%
Sep10%
Oct-4%
Nov9%
Dec-3%

Let’s calculate the downside risk of this stock based on past returns, and to keep matters simple; we will calculate using the mechanism of historical method. Let’s decide the confidence interval and time horizon.

  • Confidence interval: 75%
  • Time horizon: 1 year

Returns in sorted order

Downside Risk Example 1.1

Calculation of Max Loss

Downside Risk Example 1.2
  • Max Loss = 3
Downside Risk Example 1.3

Arranging the returns in sorted order, we will focus on the bottom 25% returns ( max loss), 3 ( 75% of 12). Hence the cutoff will be the 4th return. In simple terms, with a 75% confidence interval, we have calculated the downside risk to be -5%.

Refer to the Excel Sheet given above for detailed calculation.

Advantages

Limitations/Disadvantages

  • A false sense of security: Downside risk is a statistical technique that tries to predict based on past data patterns. Its complexity varies from asset class to asset class. For a simple financial product like equity, it could be as simple as trading prices. For intricate work like credit default swaps, it depends on many parameters like underlying financial bond prices, time to maturity, current interest rates, etc. The model you are using can work 99 times but can fail once too, and most often, this will happen when volatility is high, or markets are crashing. In short, it will fail when you need it the most. Hence due to model risk, downside risk can provide you with a false sense of security
  • Inconsistent results across models: Downside risk is as good as the model used. Based on the underlying process used, there can be variations in the work even though the underlying assumptions and the sample are the same. This is because each downside risk metric mechanism has its implicit assumptions, leading to a different output. For example, both historical simulation and Monte Carlo simulation value at risk mechanisms, but the result derived through them based on the same underlying data can differ.

Important Points to Note

Conclusion

Nobody likes losses, but the lessons from the past have taught us that financial products are unpredictable in times of distress like the 2008 economic recession or 2001 dot com bubble, the volatility and the correlation between the asset classes increases. Most often than not, it catches investors off-guard, leading to huge losses and catastrophic events. Downside risk, as a preventive measure, helps in eliminating or preparing better for such scenarios.

Recommended Articles

This has been a guide to the Downside Risk and its meaning. Here we discuss the components of downside risk, its calculation with an example, advantages, and disadvantages. You can learn more about finance from the following articles –

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