Financial Asset Risk Pricing

Application: Using Capital Markets Signals to Inform Investment Risk and Opportunities from Water Exposures

In collaboration with Equarius® Risk Analytics, we have been working on advancing applications of the capital asset pricing model (CAPM) to quantify the impact of water risks on the capital markets. The premise is that when water quantity, water quality, regulatory and reputational risks in watersheds impact corporate and civilian operations, long term opportunity cost and risk management are affected.

The research question is whether water risk exposures can be quantified as a capital markets-relevant waterBeta?

When operations are impacted, revenue, cost structure and future opportunity cost may be impacted. This, in turn may affect credit rating and price guidance outlook on a stock. In finance, this information is captured by portfolio theory models such as CAPM (Capital Asset Pricing Model) that quantify the volatility risk in a stock (or other traded security). Systemic risk can be expressed by the financial beta, or how a financial asset is impacted relative to the broader market.

To address the water case, we explored unsystemic (company- and event-specific) risks impacting the financial asset, relative to an industry-specific benchmark, e.g. DTE's water risk relative to energy utilities.

Our process to uncover waterBeta-driven volatilities in financial assets incorporates:

waterBeta = f(systemic risk, idiosyncratic risk, water risk indicators)

1. Value-at-risk analysis of stock returns over multiple year periods to capture extreme short-term volatility
2. Comparison to industry-specific benchmarks (e.g. electric utilities) to identify idiosyncratic (non-systemic) risks
3. Relation of volatility risk to operational value of the company and exposure to high water risk areas
4. Correlation analysis between idiosyncratic (company-specific) financial risk and water risk indicators
5. Use correlation metrics to modify financial beta (systemic risk) to obtain waterBeta

Students and Collaborators

Iuliana Bleanda-Mogosanu, MS/MBA, Erb Institute for Global Sustainable Enterprise/SEAS, currently at Equarius Risk Analytics and Harvard University Institute for Growth and Innovation

Sven Adriaens, BBA, Broad School of Business, Michigan State University

Dan Li, MSc, Macromolecular Science and Engineering, UM; Mingyan Tian, MSc, Environmental and Water Resources Engineering

Lydia Miller, Senior VP, Dana Investment Advisors (WI)

Tad Slawecki, MS, LimnoTech, seconded to Equarius Risk Analytics