244 PART 2 Important Financial Concepts
efficient market
A market with the following
characteristics: many small
investors, all having the same
information and expectations
with respect to securities; no
restrictions on investment, no
taxes, and no transaction costs;
and rational investors, who view
securities similarly and are risk-
averse, preferring higher returns
and lower risk.
In Practice
Financial managers, always on the
lookout for new ways to measure
and manage risk, have added
value-at -risk (VAR) techniques to
their repertoire. VAR is a statistical
measure of risk exposure that re-
flects the potential loss from an
unlikely, adverse event in a normal,
everyday market environment. It
predicts the drop in a company’s
value that will occur if things go
wrong by calculating the financial
risk in the future market value of a
portfolio of assets, liabilities, and
equity.
First used by banks and bro-
kerage firms to measure the risk of
market movements, VAR now has
proponents among nonfinancial
companies such as Xerox, General
Motors, and GTE. Unlike other risk
tools that measure risk using stan-
dard deviation, VAR is stated in
currency units: for example, VARwould represent an amount, let’s
call it Ddollars, where the chance
of losing more than Ddollars is,
say, 1 in 50 over some future time
interval, perhaps a week.
VAR shows companies
whether they are properly diversi-
fied and also whether they have
sufficient capital. Among its
other benefits, it tells managers
whether their actions are too
cautious, identifies risk trouble
spots that might not be caught,
and provides a way to compare
business units that measure per-
formance differently for internal
reporting.
For example, a bank could
take a diverse portfolio of financial
assets and calculate price swings
by measuring performance on
specific days in the past. Plotting
the percentage gain or loss for
hundreds of days would reveal thevalue at risk of that portfolio. If it
was riskier than previously
thought, traders could take cor-
rective action—selling a particular
type of security, for example—to
reduce risk.
Like any quantitative model,
VAR has its limitations. Perhaps its
biggest drawback is its reliance on
historical patterns that may not
hold true in the future.
Sources:Steve Bergsman, “Delivering the
Risk Management Goods,” Treasury & Risk
Management, downloaded from http://www.
treasuryandrisk.com/trmtechguide/
article13.cgi;Peter Coy, “Taking the Angst
Out of Taking a Gamble,” Business Week
(July 14, 1997), pp. 52–53; and Paul Hom and
Ron Tonuzi, “Value-at-Risk: Safety Net or
Abyss?” Treasury & Risk Management
(November/December 1998), downloaded
from http://www.cfonet.com;Barry Schachter, “An
Irreverent Guide to Value at Risk,” All About
Value-at-Risk(Web site), downloaded from
http://www.gloriamundi.com.FOCUS ONPRACTICE What’s at Risk? VAR Has the Answer
the market risk premium. It should now be clear that greater risk aversion results
in higher required returns for each level of risk. Similarly, a reduction in risk
aversion causes the required return for each level of risk to decline.Some Comments on CAPM
The capital asset pricing model generally relies on historical data. The betas may
or may not actually reflect the futurevariability of returns. Therefore, the
required returns specified by the model can be viewed only as rough approxima-
tions. Users of betas commonly make subjective adjustments to the historically
determined betas to reflect their expectations of the future.
The CAPM was developed to explain the behavior of security prices and pro-
vide a mechanism whereby investors could assess the impact of a proposed secu-
rity investment on their portfolio’s overall risk and return. It is based on an
assumedefficient marketwith the following characteristics: many small investors,
all having the same information and expectations with respect to securities; no
restrictions on investment, no taxes, and no transaction costs; and rational
investors, who view securities similarly and are risk-averse, preferring higher
returns and lower risk.
Although the perfect world of the efficient market appears to be unrealistic,
studies have provided support for the existence of the expectational relationship