Study of downside risk and its use in equity valuation

Abstract

Abstract: 1) Introduction and context description: Capital Asset Pricing Model (CAPM) uses variance as the measure of risk for investment portfolios. But in recent years the validity of variance as the appropriate measufgof risk has been challenged. One such challenge has been from the downside liak school of thought. It argues that investors would try to secure their positions by minimizing downside risk before trying to maximize their returns. Hence investors would demand greater compensation for holding stocks with greater downside risk. Recently there have been some rigorous empirical evidences in this regard. Post and Vliet in their paper 'Conditional Downside Risk and CAPM' have outlined the method they have used to prove that the use of Mean Semi-variance as a substitute for Mean Variance as a measure of risk gives better results. There is also research work going on about the measure of downside risk that should be used to substitute Mean Variance. There are several measures of the downside risk. Prominent among them are shortfall probability, expected shortfall, downside deviation and downside variance. A significant research work has gone into identifying the suitability of downside risk measures for equity valuation. Prominent among them are the works of Estrada and Jianguo Chan. 2) Research questions: We examined which of the downside risk measures better fit the historical India stock market data. 3) Methodology: We followed the following methodology while arriving at the conclusion: • Study of various papers on the subject of risk measures for equity evaluation. • Study of effect of these risk measure on data pertaining to Indian Stock markets. • Obtaining stock price data for various Indian companies and adjusting it for dividends, splits, bonus issues and buybacks over the past 14 years. • Running various regression models over the data obtained above and determine which risk measure is a better fit for the implied risk in the stock prices. Data Sources: Primary: • Interaction with academia: The use of Downside risk measures is a fairly well researched topic in the financial world and several models for their use in equity evaluation exist. Interaction with academia helped us to critically evaluate the measures and aid in the selection of relevant measure in the Indian context. Secondary: • Web resources: We primarily used CMIE Prowess databases for collection of stock price data. • Journal and publications: They enabled us to understand the latest pricing and valuation models. ; 4) Findings: The results do not show any definitive trend and there are no indications of downside risk measures being a better indicator of the risk than standard deviation. 5) Limitations of the study: The data used for this study extends for just about 12 years which is not considered to be sufficient length of period to comment on the suitability of a risk factor. The monthly data on risk free rate is not available and hence the rate is considered to be constant over a year. The accuracy of the risk measure is limited by the fact they have been calculated based on the data of preceding 24 months. 6) Scope for further work: The study could be repeated when data for a period of greater of 12 years becomes available. The theory behind the postulation of the downside risk measure is sound and needs to be checked in the context of other emerging markets as well, such as Vietnam, Brazil, Ukraine, etc. 7) Key words (upto five): Downside risk, CAPM Learnings from the IP process: The IP process allowed us to work independent of course restrictions and explore interesting avenues and ideas that came to us during the course of the project work. In effect it allowed us the freedom to learn about a topic by actually doing the research rather than by reading about someone eSse's observations.