Novo Nordisk ($NVO) : Risk Analysis using VaR and CVaR . A Value Investor's point of view

Summary

• A value investor’s view of the risk of an equity investment using the Novo Nordisk case ($NVO)
• Two of the most popular risk measures used by banks and other financial institutions around the world: the VaR and CVaR.
• A more dynamic use of these two metrics
• Monte Carlo simulation : building model of possible results

In the world of finance, understanding and managing risk is crucial for investors who want to safeguard their assets.

Risk management is crucial in portfolio optimization and stocks analysis when talking about investment.

VaR and CVaR are the most widely used risk measures and it’s a standard measure used by banks and financial institution in general.

Having been a value investor for several years, in this article we apply these two metrics to a real case involving Novo Nordisk stock from a “value” perspective.

After doing our due diligence and establishing a value for which we are willing to buy the stock, my final question is always: What is my risk-return ratio? And what is the MOS that could convince me to buy NVO?

What is Var .

Value-ar-risk is one of the most widely used measures of risk and has become a standard measure of risk used by banks and other financial institutions around the world

Commercial banks , for example, typically calculate a daily VAR, asking themselves how much they can lose in a day.

VAR estimates the worst-case scenario or the potential downside risk of an investment.

It calculates the maximum expected loss over a defined period, under normal market conditions, at a given confidence level.

The confidence level are 90%, 95%, or 99%. Let’s see what that means: If a stock has a VaR of -5% with a confidence level of 95%, it means its losses will not exceed -5% with a 95% probability in a given day based on historical values. Let’s practice a concrete case with the Novo Nordisk stock — $NVO

How to read it for 95%: Novo stock loss will not exceed -2.68 % on a single day with a confidence level of 95% based on its historical values over the last 3 years.

What is CVaR

Conditional Value at Risk (CVaR), also known as the expected shortfall, is a risk assessment measure that quantifies the amount of tail risk an investment has. CVaR is derived by taking a weighted average of the “extreme” losses in the tail of the distribution of possible returns, beyond the value at risk(VaR) cutoff point. Conditional value at risk is used in portfolio optimization for effective risk management.

The use of CVaR as opposed to just VaR tends to lead to a more conservative approach in terms of risk exposure.The choice between VaR and CVaR is not always clear, but volatile and engineered investments can benefit from CVaR as a check to the assumptions imposed by VaR.

Generally speaking, if an investment has shown stability over time, then the Value- at -Risk may be sufficient for risk management in a portfolio containing that investment. However, the less stable the investment, the greater the chance that VaR will not give a full picture of the risks, as it is indifferent to anything beyond its own threshold.

Let’s plot Novo CVaR

We read NVO CvAR in the same way we interpreted VaR : NVO loss will not exceed -3.91% on a single day with a confidence level of 95% based on its historical values over the last 3 years.

CVaR in real life CVaR must always be greater than VaR because CVaR is based on the worst-case scenarios of returns, which is reflected in the results shown. Safer investments (large-cap US stocks or bonds) rarely exceed VaR significantly. More volatile asset classes, such as small-cap US stocks, emerging market stocks, or derivatives, can have CVaRs that are many times greater than VaRs. Investors prefer low CVaRs.

Rolling VaR and CVaR

When we use a rolling window to compute VaR and CVaR, it provides a dynamic view of how the risk of maximum potential loss changes over time. For instance, a rising VaR and CVaR might indicate increasing risk in the asset.

In the case of NVO we see that the current VaR and CVaR is below the average mean threshold of both indicators indicating moderate risk . We have a VaR near 2.4% of against the average of 2.68%.

Ditto for CVaR.

Monte Carlo simulation

The Monte Carlo simulation example involves generating random returns based on the historical mean and standard deviation. The histogram shows the distribution of simulated portfolio or stock returns, with the VaR and CVaR threshold at the 95% confidence level marked by a red dashed line. This visualization helps to understand the potential range of future returns and the likelihood of exceeding the VaR and CVaR. Value at Risk (VaR) is a vital metric for assessing financial risk, offering a clear quantification of potential losses.

In simple terms, Monte Carlo model is used to predict the probability of different outcomes. The outcome of this model will explain the impact of risk and uncertainty in prediction and forecasting models. These risks will be presented in form of CVar and Var values.

There is a 95% probability that the stock will not lose more than -14.16% (VaR) over a given period of time (100 days), based on the Monte Carlo simulation; or the stock will not lose more than -20.82% (CVaR).

Conclusion

With a closing prince of about 133 dollars and an intrinsic value of about 80 dollars, the price of NVO is too expensive at the moment .

I really like Novo Nordisk . It is a quality stock with a great Moat that I would like to have in my stock portfolio, however, a strategy is necessary.

Then what to do ? Wait for the stock to decline or get paid by selling options in the expectation of a correction ?

It is in choosing the second scenario that VaR and CVaR come in handy , because we can try to plan for a price at which we are willing to buy the stock and get paid while waiting .

VaR and CVaR are very useful in establishing confidence levels within which to place our bet.