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
The most critical parameter to analyze any risk metric is the time horizon. This factor becomes even more critical for downside risk.The time horizon helps in limiting our analysis for a particular duration of time, making our calculation more precise and are models more robust.It should be essential to include proper sample space to make sure the time horizon you selected is unbiased and is free from cyclic deviations.
Downside risk is a study based on statistical measures.Then it becomes essential that a correct and defined confidence form has been selected because new additional calculations will be based
Benefits
Helps to plan in the worst-case scenario: if you can’t plan, you plan to fail. Downside risk allows you to prepare for the worst-case scenario by understanding how many investments could lead to losses if the projected view is wrong. It is not common for investments to be made to earn returns and meet open market rates, often set by US Treasury bonds.
But there may be scenarios where things don’t go as planned due to news or an event not being reflected in the market. Take the example of Yahoo, a search engine giant of the early 1990s with no competition. Everyone was hoping this stock would be a multi-bagger, but not everyone knew that a new market leader (Google) was on the way, and Yahoo will be if downside risk control is implemented in the systems, the losses would be much lower.
Deciding on Hedging Strategies: As explained above, the downside risk is more about being prepared when events don’t unfold as expected. This estimate helps identify when to exit an investment. As they say, you keep your profits but book your losses.
Limitations
A false sense of security: Downside risk is a statistical technique that attempts to predict based on past data patterns. Its complexity varies from one asset class to another. For a simple financial product like stocks, it could be as simple as trading prices. For complex works like credit default swaps, it depends on many parameters such as prices of the underlying financial obligations, term to maturity, current interest rates, etc.
The pattern you are using may work 99 times, but it may fail even once, and quite often this happens when volatility is high or the markets are crashing. In short, it will fail when you need it most. As a result, due to model risk, downward risk can provide you with a false sense of safety, and inconsistent results using models: the risk of disadvantage is as good as the model used.
Important Points to Note
Risk reduction strategies: Calculating downside risk helps one in identifying the correct hedging strategy. Investors and institutions should understand the financial product they are dealing with and then select a suitable downside risk metric as per their comfort and capability.
Each asset class has a different downside risk. For vanilla financial products like equity and fixed income, the downside risk is relatively easy to calculate and limited. However, for financial derivatives like options or credit default swaps, the downside is challenging to figure out and unlimited.
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 the 2001 dot com bubble, and 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.
