29 - Risk Measurement and Reporting

Question 1

How are risks quantified?

Answer 1

By assessing their:

1. Frequency
2. Severity.

Question 2

Why is it difficult to model low frequency events?

Answer 2

There is a lack of data.

Question 3

How is operational risk usually quantified?

Answer 3

1. Broad-brush addition to other risks

2. Scenario analysis

Question 4

In which circumstance is scenario analysis the most useful?

Answer 4

When it is difficult to fit full probability distributions to risk events.

Question 5

What steps are involved in scenario analysis?

Answer 5

1. Grouping risks into broad categories
2. Development of a plausible adverse scenario
3. Calculation of the consequences of the risk event occurring for each scenario.
4. Total costs calculated are taken as the financial cost of all risks represented by the chosen scenario.

Question 6

Give a drawback of a scenario testing approach.

Answer 6

The approach focuses on severity and neglects the probability of the scenario occuring.

Question 7

Define: Stress Testing

Answer 7

Involves testing for weaknesses in a portfolio by subjecting it to extreme market movements or credit or liquidity risk events.

Question 8

Give two types of stress tests.

Answer 8

1. To identify ‘weak areas’ in the portfolio and investigate the effects of localised stress situations by looking at the effect of different combinations of correlations and volatilities
2. To gauge the impact of major market turmoil affecting all model parameters while ensuring consistency between correlations while they are ‘stressed’

Question 9

Describe a ‘reverse stress test’

Answer 9

The construction of a severe stress scenario that just allows the firm to be able to continue to meet its business plan. The scenario may be extreme but it should be plausible.

Question 10

Give the limitations usually applied to stochastic modelling with regards to stress testing.

Answer 10

1. Restricting the duration or time horizon of the model
2. Limit the number of variables modelled stochastically and use a deterministic approach for the other variables.
   3, Carry out a number of runs with a different single stochastic variable and then a single deterministic run using all the worst case scenarios together.

Question 11

How is risk aggregation, to allow for correlations and inter-actions, usually performed?

Answer 11

1. Stochastic modelling - although impractical
2. Simple formulae if risk events are fully dependent or fully independent.
3. Correlation matrices
4. Copulas

Question 12

Give the main advantage and main disadvantage of risk aggregation.

Answer 12

Pro: combining risks may result in a lower total risk through diversification
Con: The time to run adequate models may be too long and this may restrict the number of scenarios that can be modelled.

Question 13

Give the Risk measure for assets risks (Strategic risk)

Answer 13

Historic tracking error and forward-looking tracking error.

Question 14

How are liability risks measured?

Answer 14

By carrying out analysis of actual vs expected experience

Question 15

Give examples of deterministic risk measures.

Answer 15

1. Notional approach
2. Factor sensitivity approach
3. Scenario sensitivity

Question 16

Give the stochastic risk measures.

Answer 16

1. Deviation, such as standard deviation and tracking error
2. VaR
3. Probability of ruin
4. TVaR

Question 17

Explain VaR

Answer 17

VaR represents the maximum potential loss on a portfolio over a given future period with a given degree of confidence.

Question 18

Explain TVaR

Answer 18

The expected loss given that a loss over the specific VaR has occured.

Question 19

How is the ratio between VaR and TVaR usefull.

Answer 19

The ratio can give an indication of the skewness of a distribution and a fatter tail.

Question 20

Give the methods used to calulate VaR and TVaR.

Answer 20

1. Empirical
2. Parametric
3. Stochastic

Question 21

Give the advantages and disadvantages of the notional approach to risk measurement.

Answer 21

Pros:
1. Simple to implement and interpret across a diverse range of organisations
Cons:
1. Potential undesirable use of a ‘catch all’ weighting for possibly heterogenous undefined asset classes.
2. Possible distortions to the market caused by an increased demand for asset classes with high weightings.
3. No allowance for concentration of risk, the risk weighting for an asset class is the same irrespective of whether the investment in that asset class consists of a single security or a variety of different securities.
4. The probability of the changes considered is not quantified.

Question 22

Give the advantages and disadvantages of the factor sensitivity approach to risk measurement.

Answer 22

Pros:
1. Increased understanding of the drivers of risk.
Cons:
1. Not assessing a wider range of risks, by focusing on a single risk factor.
2. Being difficult to aggregate over different risk factors.
3. The probability of the changes considered is not quantified.

Question 23

Give the advantages of using VaR as a risk measurement.

Answer 23

1. The simplicity of its expression
2. Intelligibility of measurement, being money
3. Its applicability to all types of risk
4. Its applicability over all sources of risk - facilitating easy comparisons between products and across businesses its inherent allowance for the way in which different risks interact to cause losses.
5. The ease of its translation into a risk benchmark.

Question 24

Give the disadvantages of VaR as a risk measure.

Answer 24

1. It gives no indication of the distribution of losses greater than the VaR.
2. It can under-estimate asymmetric and fat-tail risks as it does not quantify the size of the ‘tail’.
3. It can be very sensitive to the choices of data, parameters and assumptions
4. VaR is not always sub-additive (Aggregated)
5. If used in regulation it may encourage ‘herding’, thereby creating systematic risk.

Question 25

Give the ways in which a risk can be dealt with.

Answer 25

1. Avoided
2. Retained
3. Diversified
4. Mitigated - internally or through transfer

Question 26

How are retained risks dealt with?

Answer 26

1. Control measures
2. Reassessment of value and impact after controls
3. Risk ownership
4. Board committee/senior manager with oversight of the risk.
5. Identification of concentrations of risk and related actions.

Question 27

Describe the steps involved in risk reporting.

Answer 27

1. Identifying new risks
2. Quantifying the impact of individual risks
3. Determining appropriate control systems for specific risks
4. Monitoring the effectiveness of existing control systems
5. Assessing changes to risks faced
6. Assessing the interaction between risks
7. Assisting with pricing, reserving and determining capital requirements

Question 28

Give the external stakeholders that benefit from risk reporting and how.

Answer 28

1. Shareholders and potential shareholders - understanding the attractiveness of the business investment
2. Credit rating agencies - to help with determining an appropriate rating
3. Regulators - TO identify areas which could require greater scrutiny.

Question 29

Give the main issues facing financial product providers with regards to risk reporting.

Answer 29

1. Should the ruin probability be expressed over a single year or the whole run-off of the business.
2. A stochastic model with more than two stochastic variables is impractical, so it may be better to use a correlation matrix. However, this introduces subjectivity.
3. Interactions between risks need to be dealt with.
4. Some risks are highly subjective, such as operational risks.
5. Using past data to estimate future consequences needs to be undertaken with caution.

Question 30

Give the approaches used to measure investment risk

Answer 30

1. Retrospective tracking error
2. Forward-looking tracking error
3. Liability risks or analysis of experience
4. Value at Risk

Question 31

Describe the main contents and use of a risk register

Answer 31

1. Provides a means by which to categorise the risks to which the business is exposed.
2. Record, a possibly subjective, rating of the impact and probability of risks to give an indication of the importance of each risk to the business.
3. Record how risks may be dealt with
4. To assess the effectiveness of control measures by being conducted with and without.
5. Can help identify concentrations of risk

Question 32

Give the ways in which production and updating of a risk register can help a company

Answer 32

1. Obtain better understanding of the risks faced by the business
2. Asses how risks are changing over time
3. Identify new risks facing the business
4. Determine appropriate control systems.

Question 33

Outline the main advantages and disadvantages of aggregating capital requirements across individual risks using summing the individual capital requirements

Answer 33

Pros:
1. Simple and quick to apply
2. No assumptions are needed - objective
3. Appropriate if risks are fully dependent
Cons:
1. Risks are normally only partially dependent - inappropriate
2. This approach can overstate capital requirements
3. This can result in inefficient use of capital, opportunity cost and and increased cost of capital.

Question 34

Outline the main advantages and disadvantages of aggregating capital requirements across individual risks using a correlation matrix

Answer 34

Pros:
1. Simple to apply
2. A common and well understood method
3. Allows for partial dependency of risks
Cons:
1. Populating the matrix is subjective
2. There may be underlying assumptions that may not hold in practice - that correlations between risks do not vary
3. In particular, correlations may change during extreme market conditions

Question 35

Outline the main advantages and disadvantages of aggregating capital requirements across individual risks using stochastic modelling

Answer 35

Pros:
1. Can allow for partial dependency between risks
2. Provides a distribution of outcomes
3. Allows automatically for programmed correlations between events under each simulation and these can vary according to the simulated conditions.
Cons:
1. Can be impractical due to the long run-time period
2. Requires expertise and resources to build the model
3. Calibration and programming of the correlation rules can be particularly complex.

Question 36

Outline the main advantages and disadvantages of aggregating capital requirements across individual risks using a copula

Answer 36

Pros:
1. Allows for partial dependency between risks
2. Different forums of copula are available to suit different degrees of dependence
3. It is a sophisticated way of allowing for dependence in the tails of the distributions
4. It helps with minimising tail risk and optimising portfolios
Cons:
1. Expertise is required, mathematically complex
2. The choice of cupula and its calibration can be difficult
3. It can be difficult to explain to end users of the outputs,