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Ebook Managing downside risk in financial markets: Part 2

(BQ) Part 2 book “Managing downside risk in financial markets” has contents: Preference functions and risk-adjusted performance measures, building a mean-downside risk portfolio frontier, investment risk - a unified approach to upside and downside returns, and other contents. | Part 2 Underlying Theory This Page Intentionally Left Blank Chapter 8 Investment risk: a unified approach to upside and downside returns LESLIE A. BALZER SUMMARY The aim of this chapter is to increase the reader’s understanding of the essential nature of investment risk and of the strengths and weaknesses of various risk measures. The literature on investment risk is vast. The topic has attracted interest from academics and practitioners alike, and continues to do so – at an accelerating rate. This latter phenomenon is at least partially due to the increasing use of financial instruments with asymmetric pay-offs and to non-linear trading or portfolio management strategies. Such assets and strategies both encourage and produce essentially asymmetric investment return distributions, which in turn highlight the intrinsic shortcomings of using variance or standard deviation as the only measure of investment risk. Investors and their advisers further reinforce the trend by selecting and rewarding not only managers who produce high returns, but also those who produce asymmetric distributions of value-added above benchmark with enhanced upside and curtailed downside. By the end of this chapter, it should have become clear that there is no single universally applicable risk measure and that, as Balzer (1990, 1994) pointed out, ‘Risk, like beauty, is in the eye of the beholder.’ Furthermore, the psychological literature indicates that not only do investors behave irrationally and inconsistently over time, but that they often form their own idiosyncratic risk measures while they are reviewing the data. No single predetermined measure can handle such a situation. Continued on page 104 104 Managing Downside Risk in Financial Markets Continued from page 103 This chapter reviews most of the commonly used or proposed risk measures, points out their strengths and weaknesses, and eventually develops a unified theory of the utility of upside and downside returns relative to the