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IAI Actuarial Core Principles · Economic Modelling · Measures of investment risk

An investor compares two Indian equity funds using variance of annual returns as the risk measure. Which statement about variance as a risk measure is correct?

Variance treats positive and negative deviations from the mean alike, because it averages squared deviations. It therefore penalises gains above the mean as much as losses. It is never negative, is in squared units, and is sensitive to extreme outcomes.

  1. AIt treats upside deviations from the mean and downside deviations from the mean symmetricallyCorrect
  2. BIt measures only the probability of returns falling below zero
  3. CIt is expressed in the same units as the return, not in squared units
  4. DIt is unaffected by extreme returns because deviations are averaged
  5. It can take negative values when the mean return is negative

Explanation

Variance is the expected squared deviation from the mean, so a deviation above the mean contributes exactly as much as an equal deviation below it. Standard deviation, not variance, is in return units. Squaring magnifies extreme values, and variance is never negative whatever the mean.

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