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	*New Book on applications of downside risk*
	This book shows how researchers around the world have used the concept of downside risk.

Managing Downside Risk in Financial Markets

Frank Sortino & Steven Satchell

Publisher: Butterworth Heinemann

United States: Phone 800 366 2665, FAX 800 446 6520, e-mail orders@bhusa.com

Europe: Phone +44 (0) 1865 314627, FAX 1865 314091, e-mail bhuk.orders@repp.co.uk

Also available at Amazon.com.

(Click on image to order from Amazon.com)

Table of Contents

Applications of Downside Risk

Ch 1. The Pension Research Institute View……................…F.A. Sortino

Ch 2. The Dutch View: Developing a Strategic Plan ……..…R.H. van der Meer

Ch 3. The Consultant’s / Financial Planner’s View………......Sally Atwater

Ch 4. The Mathematician’s View of Estimation Procedures….Hal Forsey

Ch 5. A Software Developer’s View……………………….Rom & Ferguson

Ch 6. An Academic View of Alternatives………………..…Joeseph Messina

Ch 7. The Money Manager’s View……………………...…Neil Riddles

Underlying Theory

Ch 8. Deriving A Downside Risk Measure............................ Les Balzer

Ch 9 An Algorythm For Downside Risk................................Vargus

Ch 10 Utility Theory and Value Functions...............................Auke Plantinga & Sebastiaan de Groot

Ch 11 A New View…...........................................................Clarkson

Ch 12. Another Look at Utility Theory......................................Steven Satchell

Free Software included

The book contains a CD with a program for generating a continuous distribution from user data, fitting a three parameter log normal distribution to the data, and calculating upside potential and downside risk. The source code is also provided and can be used commercially without royalties. We do ask that commercial users inform clients that the calculations were made with the Forsey-Sortino methodology.

Introduction

This book is dedicated to the many students we have taught over the years, whose thought provoking questions led us to rethink what we had learned as graduate students. For all such questioning minds, we offer the research efforts of scholars around the world who have come to the conclusion that uncertainty can be decomposed into a risk component and a reward component, that all uncertainty is not bad.

Risk has to do with those returns that cause one to not accomplish their goal, which is the downside of any investment. How to conceptualize downside risk has a strong theoretical foundation that has been evolving for the past forty years. However, a better concept is of little value to the practitioner unless it is possible to obtain reasonable estimates of downside risk. Developing powerful estimation procedures is the domain of applied statistics, which has also been undergoing major improvements during this time frame.

The first section of this book deals with applications of downside risk, which is the primary concern of the knowledgeable practitioner. The second section examines the theory that supports the applications. You will notice some differences of opinion among the authors with respect to both theory and its application.

The differences are generally due to the assumptions of the authors. Theories are a thing of beauty to their creators and their devotees. But the assumptions underlying any theory cannot perfectly fit the complexity of the real world, and applying any theory requires yet another set of assumptions to twist and bend the theory into a working model. We believe that quantitative models should not be the decision maker, they should merely provide helpful insights to decision makers.

APPLICATIONS:

The first chapter is an overview of the research conducted at the Pension Research Institute (PRI) in San Francisco, California, U.S.A. References are made to chapters by other authors that either enlarge on the findings at PRI, or offer opposing views.

The second chapter by Robert van der Meer deals with developing goals for large defined benefit plans at Fortis Group in the Netherlands. The next chapter by Sally Atwater, who developed the financial planning software at Checkfree Inc., proposes a new paradigm for establishing goals for defined contribution plans, such as the bourgeoning 401 K market in the U.S. Sally offers new insights for financial planners and consultants to 401K plans

Chapter 4 by Hal Forsey explains how to use the latest developments in statistical methodology to obtain more reliable estimates of downside risk. Hal also wrote the source code for the Forsey_Sortino model on the CD enclosed with this book.

Chapter 5 by Rom and Ferguson illustrates the importance of skewness in the calculation of downside risk. Brian Rom developed the first commercial version of an asset allocation model developed at PRI in the early ‘80’s.

Chapter 6 examines alternative risk measures that are gaining popularity. Joseph Messina, chairman of the Finance Department at San Francisco State University, evaluates the Information Ratio and Value at Risk measures in light of the concept of downside deviations. Messina points out both the strengths and weaknesses of these alternative performance standards.

The final chapter in the applications section presents the case for measuring downside risk on a relative basis. Neil Riddles was responsible for performance measurement at the venerable Templeton funds. Neil is currently Chief Operating Officer at Hansberger Global Advisors. While PRI takes the contrary view expressed in chapter 2 by van der Meer, we think Neil presents his arguments well, and this perspective should be heard.

Theory

The theory section begins with a Chapter by Les Balzer, a Senior Portfolio Manager with State Street Global Advisors in Australia, and a former academic. He develops a set of properties for an ideal risk measure and then uses them to present a probing review of most of the commonly used or proposed risk measures. Les confronts the confusion of ‘uncertainty’ with ‘risk’ by developing a unified theory, which separates upside and downside utility relative to the benchmark. Benchmark relative downside risk measures emerge naturally from the theory, complemented by novel concepts such as ‘upside utility leakage’.

In chapter 9, Stephen Satchell expands the class of asset pricing models based on lower-partial moments and presents a unifying structure for these models. Steven derives some new results on the equilibrium choice of a target return, and uncovers a representative agent in downside risk models.

Next, Plantinga and de Groot relate prospect theory, value functions, and risk adjusted returns to utility theory. They examine the Sharpe ratio, Sortino ratio, Fouse index and U-P ratio to point out similarities and dissimilarities.

Our colleague in Brazil, Gustavo de Athayde, offers an algorithm in chapter 11, to calculate downside risk.

Finally, Robert Clarkson proposes what he believes to be a new theory for portfolio management. This may be the most controversial chapter in the book. While we may not share all of Roberts views, we welcome new ideas that make us think anew about the problem of assessing the risk-return trade off in portfolio management.

A tutorial for installing and running the Forsey_Sortino model is provided in the appendix. This tutorial walks the reader through each step of the installation and demonstrates how to use the model. The CD provided with this book offers two different views of how to measure downside risk in practice. The program, written by Hal Forsey in Visual Basic, presents the view of PRI. The Excel spreadsheet by Neil Riddles presents the view of the money manager.

It is our sincere hope, that this book will provide you with information that will allow you to make better decisions. It will not eliminate uncertainty, but it should allow you to manage uncertainty with greater skill and professionalism.

Sincerely,

Frank Sortino and Stephen Satchell

Appendix: Tutorial for free software to calculate upside potential and downside risk