Introduction
Risk assessment in the financial market is regarded as one of the key insurance tools for effective asset pricing. Since the prices of the assets are formed in accordance with the market principles, and stock investment strategies, the risks play an important role in defining these strategies. Therefore, the importance of the risk assessment and research for the process of asset pricing is important for the opportunity to decrease the risks of investment, and mitigate the investment risks associated with portfolio parameters changing.
Literature Review
In general, portfolio risks are divided into two main categories: diversifiable (or unsystematic), which are associated with individual assets, and undiversifiable (systematic) risks, which are common for the entire market. Downs and Patterson (2005) claim that diversification of the risks involves sending off the existing risks for the lower levels of investments. This is generally performed by unifying various assets into a single portfolio. Surely, this will be impossible for the entire market, and properly diversified assets tend to stabilize the entire market (Benjamin, Sirmans et.al. 2001). However, Abdallah (2004) emphasized that this stabilization is not effective for previously unstable markets. Brunnermeier (2001) stated the fact that a rational investor would never deal with diversifiable risks, while higher returns are possible only if the return compensates for the taken risks. (Lawrence, 2007; Isaac and James, 2003; Hagstrom, 2001; Harrison, 2004)
Considering the factor of asset risks, the CAPM context should be regarded as well. This means that portfolio risks are featured with a higher level of variance; however, this causes less predictability level for risk assessment. Bansal and Yaron (2002, p 5) emphasized the following statement:
Estimates of economic risk premium assigned by models with non-traded factors are almost always much larger (in absolute value) than the estimates of the premium on maximum-correlation portfolios. Indeed, the absolute size of the economic risk premium assigned by these models is often completely unrealistic. Moreover, the risk premium estimates tend to exhibit large (absolute) biases and standard errors and can be sensitive to the choice of moment conditions.
In the light of this statement, it should be emphasized that the premium of portfolios with a maximum level of correlation is generally estimated with little bias, while this may influence the effectiveness of the risk assessment of the entire portfolio. As for the general securities of portfolio assessment, Cooper and Edgett (2002) illustrated that the complete market could use securities for regulating the marginal rate of portfolios and substitutions of every investor’s diversification strategy. Hence, considering the rational expectations, including subjective opportunities of investment risk assessment, the capital markets of the whole world ensure the uniqueness of the discount factor that is often linked with the risk factors of the common currency. (Balduzzi and Robotti, 2009; Campbell and Viceira, 2002; Murphy, 2000; Poon and Stapleton, 2005)
Methodology
The key principles of risk assessment research that should be used in the paper are closely linked with the practical application of risk evaluation and investment into risky assets. Harrison (2004) claims that risk assessment is mainly individual, and there are no two similar portfolios, with similar risk levels, while any recommendation associated with evaluating portfolios maybe just a set of general rules. (Worzala and Sirmans, 2000; Li, 2006; Neely and Roy, 2001)
The research will be based on the risky investment instances, and assessment of the investment principles of those investors who dared to invest. Hence, the diversification principles will be studied as the inevitable part of investment risk management strategy. This will be performed in accordance with an investment risk assessment mode offered by Constantinides and Ghosh (2008). They offered the model associated with elasticity risk aversion and the opportunity of separation. Therefore, the aggregate consumption that is based on growth rates, involves a long-run risk, as well as it is featured with the fluctuating volatility.
Where:
- Xt – long run risks
- σt – fluctuating volatility
Then, in accordance with the recommendations by Huffman (2002), the time varying risk premium should consider the rates of conditional volatility. Jones (2005) emphasized that this would define the growth rates of the assets. However, the conditions of fluctuating economy are linked with the price-dividend ratios that are defined by the economic growth, and instability level. Jones (2001) emphasizes that economic shocks may cause a positive risk premium, nevertheless, it is more an exception then a rule; hence, these instances will not be taken for the analysis. The expected growth for risky portfolios should be analyzed from the perspective of positive and negative risk premiums. (Sun and Yung, 2009; Milne, 2005)
Alternative method may be based on short run risk assessment principle associated with production levels, demand, and production-based asset pricing. This model is linked with the standard consumption assessment model. This principle unites the stock return parameters, and production function. Therefore, the marginal rates of the economic system are interfered. The economic forecasts are often regarded as the risk assessment tool; however, stock returns also define risk variables and economic activity levels. (Li, 2004; Cochrane, 2004)
Results
The achieved results will involve the long and short run risks for various portfolios regardless of the market origin. Since the actual importance of the analysis is explained by the values of proper asset pricing, the necessary risk management tools that will help investors diversify risks properly, may be regarded as the necessary tool for safe investment, as well as the market stabilization.
Linear factors of risk assessment will be required for proper evaluation of the portfolio parameters, including efficient frontier, risk free rates, tangency portfolio, as well as capital asset lines. The achieved data will be needed for evaluating the possible risk variances, as well as the origins of the risks that are needed for market stabilization, evaluation of the risk management effectiveness, and pricing model of the assets.
Analysis
The analysis of the results will involve the CAPM based assessment of the prices, and evaluation of the risk levels in this context. Furthermore, the results of the entire research may be analyzed considering the principles efficient market hypothesis jointly with a modern portfolio theory. This will help to review the problem from a slightly different angle, while the risk diversification principles may be the necessary tool for evaluating the general values of assets and prices.
As for the matters of paper significance, the results will be used for developing the risk assessment concept as a tool for stabilizing the financial market in general.
Conclusion
Asset pricing principles can not be regarded as an effective investment toolset, as these require proper risk assessment strategy. Risk diversification principles may be regarded as a basis for creating proper investment strategies depending on the pricing process.
Reference List
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