Ch29: Risk measurement and reporting

Question 1

Scenario analysis steps (4)

Answer 1

Looks at the financial impact of a plausible and possible adverse set of events or sequences of events. Deterministic method of evaluating risk.

Steps:
- Risk exposures grouped into broad categories, involves input from wide range of seniors
- For each group of risks a plausible adverse scenario is developed, plausible such that the
consequences of the risk event can be determined
- For each scenario must translate the scenario into assumptions for the various risk factors in
the model. Consequences of the risk event occurring are then calculated
- Total costs are the financial cost of each risk combines under the chosen scenario

Question 2

Stress testing definition

Answer 2

Financial stress test is the projection of the financial condition of a company under a specific adverse event over a period of time, e.g. financial impact on a company if say interest rates change by x%

Question 3

Advantages and disadvantages of VaR (5&5)

Answer 3

Advantages:
- Simplicity of its expression
- Interpretability of its units i.e. money
- Applicability to all types of risks
- Applicability over all sources of risk (source = products or businesses; can be compared)
- Ease of translation into a risk limit

Disadvantages:
- No indication of the distribution of losses greater than VaR
- It can underestimate asymmetric and fat-tail risk risks as it does not quantify the size of the
‘tail’; i.e. only have only 5% change of loss greater than R1m but not what that size could be
- Very sensitive to the choices of data, parameters and assumptions
- VaR is not always sub-additive
- If used in regulation, it may encourage herding and increase systematic risk

Question 4

Importance of risk reporting for management and other stakeholders (10)

Answer 4

For management:
- Identify new risks faced by the business
- Obtain better understanding of risks faced by the business (quantifying financial impact)
- Determine appropriate risk controls to manage specific risks
- Monitor and manage effectiveness of risk control systems
- Assess whether risks faced are changing over time
- Assess the interaction between individual risks
- Appropriately price, reserve and determine any capital requirements for its business

For other stakeholders:
- Gives greater understanding of attractiveness of business for investment
- Help credit rating agencies to determine appropriate rating for business
- Give regulator greater understanding of areas within business which could require more
scrutiny.

Question 5

Issues with reporting risk

Answer 5

• At enterprise level; costly task to analyze data from diverse business units; trade-off between
  gains from diversification and costs of additional analysis required.
• Whether to use a qualitative or quantitative approach
• For qualitative how to communicate best:
  + level of uncertainty in figures given
  + limitations of assessment approach used
• Tailoring to the needs of the intended audience

Question 6

Methods of aggregating risk (4)

Answer 6

• Summing individual capital requirements
• Correlation matrix
• Stochastic modelling
• Copulas