Downside Risk

What Is Downside Risk?

Downside risk is an assessment of a security's possible loss in value assuming market conditions encourage a decline in that security's price. Contingent upon the measure utilized, downside risk makes sense of a worst situation imaginable for an investment and demonstrates how much the investor stands to lose. Downside risk measures are considered [one-sided](/one-followed test) tests since the potential for profit isn't thought of.

Understanding Downside Risk

A few investments have a finite amount of downside risk, while others have infinite risk. The purchase of a stock, for instance, has a finite amount of downside risk limited by zero. The investor can lose their whole investment, yet not more. A short position in a stock, in any case, as achieved through a short sale, involves unlimited downside risk since the price of the security could rise indefinitely.

Essentially, being long a option — either a call or a put — has a downside risk limited to the price of the option's premium, while a "naked" short call option position has an unlimited potential downside risk since there is theoretically no restriction to how far a stock can climb.

A naked call option is viewed as the riskiest option strategy, since the seller of the option doesn't claim the security, and would need to purchase it in the open market to satisfy the contract. For instance, in the event that you sell a call option with a strike price of $1 and the stock trips to $1,000 by contract expiration, you would need to purchase the stock at $1,000 and sell it at $1; not a decent return on investment

Investors, traders, and analysts utilize a variety of technical and fundamental metrics to estimate the probability that an investment's value will decline, including historical performance and standard deviation calculations. By and large, numerous investments that have a greater potential for downside risk likewise have an increased potential for positive rewards.

Investors frequently compare the potential risks associated with a specific investment to potential rewards. Downside risk is as opposed to upside potential, which is the probability that a security's value will increase.

Illustration of Downside Risk: Semi-Deviation

With investments and portfolios, an exceptionally common downside risk measure is downside deviation, which is otherwise called semi-deviation. This measurement is a variation of standard deviation in that it measures the deviation of just terrible volatility. It measures how large the deviation in losses is.

Since upside deviation is likewise utilized in the calculation of standard deviation, investment managers might be punished for having large swings in profits. Downside deviation resolves this problem by just zeroing in on negative returns.

Standard deviation (\u03c3), which measures the dispersion of data from its average, is calculated as follows:
$\begin &\sigma = \sqrt{ \frac{ \sum_^ (x_i - \mu)^2 } } \ &\textbf \ &x = \text \ &\mu = \text{Data set's average} \ &N = \text \ \end$

The formula for downside deviation utilizes this equivalent formula, however rather than utilizing the average, it utilizes some return threshold — the risk-free rate is frequently utilized.

Expect the accompanying 10 annual returns for an investment: 10%, 6%, - 12%, 1%, - 8%, - 3%, 8%, 7%, - 9%, - 7%. In the above model, any returns that were under 0% were utilized in the downside deviation calculation.

The standard deviation for this data set is 7.69% and the downside deviation of this data set is 3.27%. This shows that around 40% of the total volatility is coming from negative returns and suggests that 60% of the volatility is coming from positive returns. Broken out along these lines, obviously the majority of the volatility of this investment is "great" volatility.

Different Measures of Downside Risk

The SFRatio

Other downside risk measurements are here and there employed by investors and analysts also. One of these is known as Roy's Safety-First Criterion (SFRatio), which permits portfolios to be assessed in view of the likelihood that their returns will fall below a base wanted threshold. Here, the optimal portfolio will be the one that limits the likelihood that the portfolio's return will fall below a threshold level.

Investors can utilize the SFRatio to pick the investment that is probably going to accomplish a required least return.

VaR

At an enterprise level, the most common downside risk measure is likely Value-at-Risk (VaR). VaR estimates how much a company and its portfolio of investments could lose with a given likelihood, given regular market conditions, during a set time span like a day, week, or year.

VaR is routinely employed by analysts and firms, as well as regulators in the financial industry, to estimate the total amount of assets expected to cover potential losses anticipated at a certain likelihood — say something is probably going to happen 5% of the time. For a given portfolio, time horizon, and laid out likelihood p, the p-VaR can be portrayed as the maximum estimated loss during the period on the off chance that we prohibit more terrible results whose likelihood is not exactly p.

Features

• A few investments have an infinite amount of downside risk, while others have limited downside risk.
• Instances of downside risk calculations incorporate semi-deviation, value-at-risk (VaR), and Roy's Safety First ratio.
• Downside risk is a general term for the risk of a loss in an investment, rather than the symmetrical probability of a loss or gain.
• Downside risk is an assessment of a security's likely loss in value assuming that market conditions encourage a decline in that security's price.