Value at Risk

F&S INVESTMENTS: UNDERSTANDING VALUE AT RISK

Introduction

In the financial market that is a marketplace in which individuals trade financial commodities, securities including equities, bonds, derivatives and currencies, and any other fungible things at lower transaction costs and at prices adjusted to supply and demand, clients are searching for investments that both provide high returns and protect the value of the initial principle invested in the hedge funds due to increasing risk in capital markets. The purpose of this report is to evaluate new investment strategies by using Value at Risk (VaR) to determine the effects of adding two new assets to existing portfolio of funds and to make some recommendations about which asset to add and how to market this new fund in the light of the implications of this policy change.

For the aim stated above, two possible categories of assets are considered to be added to existing portfolio focused on North-American-based equities and bonds, which one is a portfolio of corporate bonds from developed markets and the other is a portfolio of equities from emerging markets. After the comparison of these two different kinds of portfolios and making analysis capturing advantages and disadvantages of each, discussion will be provided and the final recommendation will be made.

Methods and Results

The first task that is needed to be achieved is to understand the characteristics of already existing overall portfolio of F&S Investments and also other assets similar to those considered to be added. To be able to compare them, the end-of-day values, in other words daily price levels and changes, over the past two years were found for the existing portfolio and proposed international portfolio. The changes in the prices for the portfolios indicate relative attractiveness in terms of volatility/stability and return. The first remarkable difference between developed market bonds and emerging market equities is fluctuations in price level. If one invests in bonds market, the value of investment is expected to be stable whereas equities market has a lot of volatility, which is an undesirable situation; because investors cannot predict how much they will earn or loss unlike bonds whose interest rate doesn’t change, so it is possible to know the amount of revenue expected. However, if relative value of these assets is taken into account, it is obvious that emerging market equities have been more valuable than bonds over the past two years.

Additionally, according to graphs in Exhibit 2, return investors may have is more likely to be higher in equities market than in bond market even if huge loss is also possible. But, it can be said that developed market bond portfolio has followed a stationary process which means returns are steady and parameters such as mean or standard deviation doesn’t change dramatically over time. So, bond portfolio has a trend for returns fluctuating very close around the mean while returns emerging market portfolio provides are non-stationary.