Cube RiskMay 19, 2014 - 10:48
One of the key outputs of Cube Research is our Risk Score. Our Risk Score is a value that allows you to compare the risk of a structured product with the risk of another structured product, or with a fund or other investment.
Our Risk Score is based on the annualized returns from the range of possible maturity values of each product. We look at what may happen, the annualised return that you would receive and the chances of each outcome. We use this assessment to calculate the overall volatility of the product and place it on the Synthetic Risk and Reward Indicator scale, something the European regulator requires for all traditional funds.
Volatility is one of the most common ways used to identify the riskiness of investments. Both the Synthetic Risk and Reward Indicator (1 to 7) and the Distribution Technology risk scores (a 1 to 10 scale favored by the majority of UK financial advisers) are based on volatility. Being able to calculate a volatility measure for a structured product allows ‘apples with apples’ comparisons with other investment types.
One characteristic of structured investments that we need to be aware of is the fact that they can offer a very different pattern of returns to funds or other ‘non-structured’ assets. So our challenge is to calculate the volatility of a structured investment that reflects this non-linear pattern of returns, but still allows the volatility to be compared with that of more traditional investments.
Taking into account the fact that investors use volatility as a proxy for riskiness, we consider potential returns and the risk of loss to define our volatilities.
We base our risk assessments on a way of calculating volatility that was proposed by the European regulators, building on their methodology to make it robust and repeatable for analysing structured investments.
Cube’s risk measures take into account the different returns that a structured investment delivers across a wide spectrum of potential market scenarios. We simulate the way that the underlying assets may behave in the future based on how they have performed in the past. This allows us to stress test the product, and provides a reliable estimate of the scale and probability of returns that you may receive if you choose to invest in these products.
Cube Risk score
As described above, the Cube’s analysis is based on the annualised returns of investments if held to a specified maturity. It is not an attempt to estimate the likely volatility of the price of a product throughout its life, but instead an assessment of the volatility of returns that the product will offer if held to maturity. We present our Risk assessments in three ways:
- We show the volatility of each product; this is a percentage number that reflects the riskiness of an investment and can be compared with the riskiness of other assets
- The Cube Risk Score places an investment’s risk on the Synthetic Risk and Reward Indicator 1 to 7 scale. These are buckets of volatility that have been defined by the European regulator that are used by all funds. Because the buckets are quite wide, we have added a decimal place; this allows you to see where in each bucket a product is.
- We also use the volatility number to place structured investments on a 1 to 10 scale. This is a popular scale with many advisers and is used by many risk-profiled funds. In this case each bucket is 2.6% wide from 0% to 26%.
Figure 1; Volatility, Cube risk and 1-10 volatility scale
|1 to 10
Market and issuer risk
The key risks associated with structured investments are the performance of the underlying assets, however investors are often also exposed to the risk of issuer default.
We therefore also calculate a risk score based on both market risk and issuer risk. We use the credit default spread (CDS) of the issuer to adjust the returns that you will receive. This adjustment will increase the volatility of a product and so increase the Risk Score. The Risk Score for products issued by a bank with a higher CDS will increase more than a product issued by a bank with a lower CDS. For collateralised credit-enhanced products we use the CDS of the companies that the product is linked to.
Other measures of risk
If you would rather use a more specific measure of risk, we also calculate the chance of loss the expected loss and the average tail return.
The chance of loss is a straightforward measure that the maturity value of the product will be less than current price of the product.
The expected loss is the product of the chance of loss and the average loss.
The average tail return is the average of the worst 10% of the results from our simulations. This is a useful measure as it offers you an estimate of the return from a “worst case” scenario.