Read on to learn the applications and examples of standard deviation in finance.
Standard deviation is a statistical measure that quantifies the dispersion or spread of a dataset. You can widely use it in finance to assess the risk of an investment, compare the risk of different investments, and optimize the risk-return trade-off in a portfolio.
In this blog, we will explore various applications of standard deviation in finance and provide fully worked examples to illustrate its usage. Besides, we will cover how we can use standard deviation in the following:
- Risk Assessment
- Portfolio Optimization
- Option Pricing
- Credit Risk Analysis
- And Financial Forecasting
Therefore, by the end of this blog, you will have a deeper understanding of how you can utilize standard deviation in finance and how it can help you make informed investment decisions.
Standard deviation is a popular measure of risk in finance. It quantifies the volatility or fluctuation of an investment’s return over a given period of time. The higher the standard deviation, the more volatile the investment and the higher the risk.
For example, consider a stock that has an average return of 10% per year with a standard deviation of 20%. This means that the stock’s return is likely to vary by 20% around its average return of 10%. In other words, the stock’s return could be as low as -10% (10% – 20%) or as high as 30% (10% + 20%) in a given year.
To compare the risk of different investments, we can use the standard deviation of their returns.
For example, consider two stocks A and B with the following returns and standard deviations:
Stock A: Average return = 10%, Standard deviation = 20%
Stock B: Average return = 12%, Standard deviation = 15%
Although stock B has a higher average return, it is less risky than stock A because its standard deviation is lower. In other words, stock B’s return is more predictable and stable compared to stock A’s return.
Modern Portfolio Theory (MPT) can make use of standard deviation to optimize the risk-return trade-off in a portfolio. MPT is a mathematical framework that helps investors construct portfolios that maximize expected returns for a given level of risk or minimize risk for a given level of expected returns.
Standard deviation can measure the risk of a portfolio—known as the portfolio’s volatility. A portfolio with a high standard deviation is riskier, while a portfolio with a low standard deviation is less risky.
To illustrate how you can use standard deviation in portfolio optimization, let’s consider a portfolio with two assets: A and B.
The following table shows the expected returns and standard deviations of the assets and the portfolio:
|Asset||Expected Return||Standard Deviation|
The expected return of the portfolio is the weighted average of the expected returns of the assets, where the weights represent the proportions of the portfolio invested in each asset.
For example, if the portfolio is equally invested in both assets (50% in asset A and 50% in asset B), the expected return of the portfolio is 11% (0.5 * 10% + 0.5 * 12%).
The standard deviation of the portfolio is a measure of the portfolio’s risk, which is the volatility of its returns. We can calculate it using the variance-covariance method, which takes into account the correlations between the returns of the assets.
To optimize the risk-return trade-off in the portfolio, we can use standard deviation to construct an efficient frontier diagram.
An efficient frontier is a graphical representation of the optimal portfolios that maximize expected returns for a given level of risk or minimize risk for a given level of expected returns.
Further, the efficient frontier is plotted using the expected returns of the portfolios on the y-axis and the standard deviations of the portfolios on the x-axis.
Portfolios on the efficient frontier are most efficient because they offer the highest expected returns for their level of risk or the lowest risk for their level of expected returns.
Portfolios below the efficient frontier are inefficient because they offer lower expected returns for their level of risk or higher risk for their level of expected returns.
Besides, the Black-Scholes option pricing model also incorporates the use of standard deviation. It is a widely used model to determine the theoretical value of European call-and-put options.
A call option gives the holder the right to buy an asset at a predetermined price (strike price) on or before a certain date (expiry date), while a put option gives the holder the right to sell an asset at a predetermined price on or before a certain date.
The Black-Scholes model assumes that the returns of the underlying asset follow a log-normal distribution. Wondering what is log-normal distribution? Well, it is a type of probability distribution characterized by a skewed distribution with a long tail on the right.
The Black-Scholes model uses standard deviation to measure the volatility of the underlying asset’s returns, which is an important factor in determining the option’s value.
The Black-Scholes formula for a European call option is:
Call option value = S * N(d1) – X * e^(-rT) * N(d2)
- S is the spot price of the underlying asset
- X is the strike price of the option
- T is the time to expiration in years
- r is the risk-free interest rate
- N(d1) and N(d2) are the cumulative standard normal distribution functions of d1 and d2, respectively
- d1 and d2 are defined as follows:
d1 = (ln(S/X) + (r + sigma^2/2) * T) / (sigma * sqrt(T))
d2 = d1 – sigma * sqrt(T)
where sigma is the standard deviation of the underlying asset’s returns.
The Black-Scholes formula for a European put option is:
Put option value = X * e^(-rT) * N(-d2) – S * N(-d1)
where N(-d1) and N(-d2) are the cumulative standard normal distribution functions of -d1 and -d2, respectively.
The Black-Scholes model has several assumptions, including the assumption of continuous trading, no dividends, and constant volatility.
However, it remains a widely used model in practice and has been the basis for developing more sophisticated option pricing models.
Standard deviation also calculates the implied volatility of an option. This means it helps to calculate the market’s estimate of the future volatility of the underlying asset’s returns.
The implied volatility is derived from the option’s market price using the Black-Scholes model or other option pricing models.
It is a useful measure for comparing the relative value of options with different strike prices and expiration dates.
For example, consider a stock with a current price of $100 and two call options with the same expiration date but different strike prices:
- Call option 1: Strike price = $95, Market price = $5
- Call option 2: Strike price = $105, Market price = $2
You can calculate the implied volatilities of the call options using the Black-Scholes model or other option pricing models. If the implied volatility of call option 1 is higher than that of call option 2, it means that the market expects the stock’s returns to be more volatile in the future. Thus, it implies a higher risk.
Credit Risk Analysis
With standard deviation, you can also get the credit risk analysis. This analysis can measure the risk of default by a borrower.
Credit risk is the risk of loss due to a borrower’s inability to make timely payments on its debt obligations.
Standard deviation calculates credit risk measures such as credit value at risk (CVaR). It is a measure of the potential loss due to credit risk over a certain time horizon.
Further, CVaR is the expected loss above a certain confidence level, which is typically set at 95%.
For example, consider a portfolio of loans with a total value of $1,000 and a CVaR of $50. This means that there is a 95% probability that the portfolio‘s losses due to credit risk will not exceed $50 over a certain time horizon. If the portfolio experiences losses above $50, the losses are considered “tail losses” because they lie in the “tail” of the loss distribution beyond the 95% confidence level.
Financial forecasting uses the standard deviation to measure the uncertainty of financial projections.
Besides, financial projections are estimates of future financial performance based on assumptions about future market conditions and business developments.
Additionally, standard deviation calculates the confidence intervals of financial projections. This is the range of values within which the actual results are likely to fall with a certain confidence level.
For example, if a financial projection has a 95% confidence interval of +- 10%, it means that there is a 95% probability that the actual result will fall within the range of the projection plus or minus 10%.
In this blog, we have explored various applications of standard deviation in finance. This includes risk assessment, portfolio optimization, option pricing, credit risk analysis, and financial forecasting. Besides, we have also provided fully worked examples to illustrate the usage of standard deviation in these contexts.
Standard deviation is a powerful tool that helps investors and analysts make informed decisions. They can do so by quantifying the risk and uncertainty of financial investments and forecasts. Further, it is an essential concept in finance that should be understood by anyone involved in financial planning and analysis.