29 - Risk Measurement and Reporting Flashcards
How are risks quantified?
By assessing their:
- Frequency
- Severity.
Why is it difficult to model low frequency events?
There is a lack of data.
How is operational risk usually quantified?
- Broad-brush addition to other risks
2. Scenario analysis
In which circumstance is scenario analysis the most useful?
When it is difficult to fit full probability distributions to risk events.
What steps are involved in scenario analysis?
- Grouping risks into broad categories
- Development of a plausible adverse scenario
- Calculation of the consequences of the risk event occurring for each scenario.
- Total costs calculated are taken as the financial cost of all risks represented by the chosen scenario.
Give a drawback of a scenario testing approach.
The approach focuses on severity and neglects the probability of the scenario occuring.
Define: Stress Testing
Involves testing for weaknesses in a portfolio by subjecting it to extreme market movements or credit or liquidity risk events.
Give two types of stress tests.
- 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
- To gauge the impact of major market turmoil affecting all model parameters while ensuring consistency between correlations while they are ‘stressed’
Describe a ‘reverse stress test’
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.
Give the limitations usually applied to stochastic modelling with regards to stress testing.
- Restricting the duration or time horizon of the model
- 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.
How is risk aggregation, to allow for correlations and inter-actions, usually performed?
- Stochastic modelling - although impractical
- Simple formulae if risk events are fully dependent or fully independent.
- Correlation matrices
- Copulas
Give the main advantage and main disadvantage of risk aggregation.
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.
Give the Risk measure for assets risks (Strategic risk)
Historic tracking error and forward-looking tracking error.
How are liability risks measured?
By carrying out analysis of actual vs expected experience
Give examples of deterministic risk measures.
- Notional approach
- Factor sensitivity approach
- Scenario sensitivity
Give the stochastic risk measures.
- Deviation, such as standard deviation and tracking error
- VaR
- Probability of ruin
- TVaR
Explain VaR
VaR represents the maximum potential loss on a portfolio over a given future period with a given degree of confidence.
Explain TVaR
The expected loss given that a loss over the specific VaR has occured.
How is the ratio between VaR and TVaR usefull.
The ratio can give an indication of the skewness of a distribution and a fatter tail.
Give the methods used to calulate VaR and TVaR.
- Empirical
- Parametric
- Stochastic
Give the advantages and disadvantages of the notional approach to risk measurement.
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.
Give the advantages and disadvantages of the factor sensitivity approach to risk measurement.
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.
Give the advantages of using VaR as a risk measurement.
- The simplicity of its expression
- Intelligibility of measurement, being money
- Its applicability to all types of risk
- 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.
- The ease of its translation into a risk benchmark.
Give the disadvantages of VaR as a risk measure.
- It gives no indication of the distribution of losses greater than the VaR.
- It can under-estimate asymmetric and fat-tail risks as it does not quantify the size of the ‘tail’.
- It can be very sensitive to the choices of data, parameters and assumptions
- VaR is not always sub-additive (Aggregated)
- If used in regulation it may encourage ‘herding’, thereby creating systematic risk.