Saturday, November 15, 2008

Measures of Risk-Return

Since risk is inherent to the investment process, mutual fund investors must be adequately and consistently rewarded for the risks they assume. Prudent research means searching for fund managers who consistently produce returns justifying the risks they have taken. This can be justified with the help of Risk- Return Ratio.

The Risk- Return Ratio is a measure of the relation between the risks inherent in a position compared to its potential gain. It is a key factor which helps in deciding where an investor should invest by estimating which funds provide greatest amount of return with the least amount of risk.

The idea is to measure the rate of return achieved by a fund relative to the amount of risk taken en-route. By using this risk-return relationship, we try to compare the comparative strength of the mutual fund in a better way.

This project therefore attempts to study a few statistics which makes it possible to more precisely quantify the relationship between risk and return. These measurements help determine:

Ø A funds volatility (Standard Deviation)

Ø How closely a fund mirrors a particular market index (R2)

Ø How volatile a fund is compared with that market index (Beta)

Ø How much of funds risk- adjusted return is created by a talented manager (Alpha)

Ø Excess return for each unit of risk taken by the fund (Sharpe Ratio)

Ø Excess returns a fund generates for each unit of market risk it takes (Treynor Ratio)

Ø Skill of fund manager (Information Ratio)

Ø Added value that depends on the relative risks of the funds (M2)

Ø Excess return per unit of risk based on downside semi-variance (Sortino Ratio)


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