PAPER WRAP-UP: Problems of Correlation in Financial Risk Management – the Contribution of Microfinance by Karel Janda and Barbora Svarovska

Written by Karel Janda and Barbora Svarovska of Charles University in Prague, MPRA Paper Number 19486, December 2009, published by the Munich Personal RePEc Archive (MPRA), available here: http://www.microfinancegateway.org/p/site/m//template.rc/1.9.41395

*It should be noted that the findings of the research project proposed in this paper are not included, but will be published in a forthcoming paper from the Czech Science Foundation.

The authors begin with a general introduction of the microfinance industry. As the authors explain, the majority of microfinance institutions (MFIs) have not been profitable enterprises. As such, external forms of funding play an important role in the industry. MFIs’ external funding may take different forms – from donations, grants and non-commercial loans to deposits and private capital.

The authors then introduce microfinance in the context of investor portfolios and risk management. They survey several research papers that have explored the potential of MFIs for portfolio enhancement and diversification:

1. Kraus and Walter (2008) examine the correlation of MFIs’ performance to international as well as to local markets. In terms of absolute market risk interconnection, they found that MFIs are not correlated with global capital markets, while there was some correlation with domestic markets. Kraus and Walter conclude that “MFIs may have useful diversification value for international portfolio investors able to diversify away from country risk exposures.” (Kraus and Walter, 2008).

2. Galema, Lensink and Spierdijk (2008) investigate whether adding microfinance funds to a portfolio of risky international assets (equity and bond investments) is beneficial in terms of diversification. They suggest that microfinance may indeed be attractive for investors seeking a better risk-return profile.

The authors proceed with the proposed research topic of the paper, which is to analyze the risk characteristics and performance of microfinance investment funds against certain equity and fixed income indices over a defined study period. As the authors explain, the advantage of evaluating these vehicles is that they publish their net asset values (NAV) monthly. As such, the authors can evaluate their performance during the recent, global financial turmoil.

The authors’ hypothesis that the underlying assets of MIVs are not correlated to global markets is backed by two special features of MFIs. First, MFIs manage risk in ways that are uncommon in developed markets. These include group-lending and short-term, small-size loans with a high frequency of installments and flexible payment schedules. Second, microfinance customers are usually small entrepreneurs who operate within a close community. Their exposure to the formal domestic economy and international markets is therefore limited.

The total risk of an asset is measured by the standard deviation of monthly returns. To measure the risk of an asset within a broader portfolio, the authors use historical portfolio beta and the portfolio R-squared measures that are both derived from the Capital Asset Pricing Model (CAPM), a model often used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio.

The coefficient beta measures the correlation of that asset to the performance of a benchmark index or market portfolio. A beta equal to zero signifies that a given asset is not correlated to the benchmark portfolio and therefore may help to reduce the overall risk of a portfolio.

To measure the return of an asset, the authors propose using Jensen’s alpha, which measures the added return of a portfolio against its theoretical expected return implied by the CAPM. Positive alpha is therefore attractive from the point of view of investors. The authors also propose using the Sharpe ratio, which measures how much the excess return compensates the investor for a riskier asset. Finally, the authors propose using the Treynor ratio, a measure of a portfolio’s performance with respect to the portfolio’s systematic risk exposure. The higher the Treynor ratio, the better the investment returns, adjusted for systematic risk.

As the author explains, the actual research of the proposed project outlined in this paper is currently being conducted in the Czech Science Foundation.

By Jay Kumar, Research Assistant

Additional Sources:
1.) Source Article: http://www.microfinancegateway.org/gm/document-1.9.41395/The%20Problems%
2.) Kraus and Walter (2008): http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1300771
3.) Galema, Lensink and Spierdijk (2008): http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1286769

Similar Posts: