Chapter 29 - Risk measurement and reporting Flashcards
Outline how a model could be used to assess a risk event
Distributions need to be assigned to both the probability and severity of the risk event (unless the latter is a fixed amount rather than a RV, such as for a without profit term assurance policy).
To quantify the risk simply, the company could define an event and then use historical data to determine a probability distribution for that event. Alternatively, the frequency of the event could be defined and this could be used to determine the loss parameter.
A decision needs to be made as to whether a STOCHASTIC or DETERMINISTIC model is appropriate.
The availability of data to parameterize the model may influence the decision as to which model (if any) is used. This is particularly important when considering RARE EVENTS.
State 5 ways of evaluating risks
- Scenario analysis
- Stress testing
- Combined stress and scenario testing
- Reverse stress testing
- Stochastic modelling
Scenario analysis
- looks at the financial impact of a plausible and possibly adverse set of events or sequences of events.
- It is a deterministic method of evaluating risk
- it is frequently used when evaluating operational risks but can also be used to assess the impact of financial risks and emerging risks
Outline 4 steps that should be involved in a scenario analysis to evaluate operational risk
- Group risks into broad categories. This should involve input from a wider range of senior individuals in the organization.
- Develop a plausible adverse scenario of risk events for each group of risks, which is REPRESENTATIVE of ALL the risks in the group.
- Calculate the consequences/costs of the risk event occurring for each scenario, again involving senior staff.
- Calculate the total costs of all risks represented by the scenario.
What is stress testing?
A projection of the financial condition of a company under a specific adverse event over a period of time
Stress testing is a deterministic method of modelling EXTREME risk event. It is commonly used to model extreme market movements, but can be applied to other risks. (e.g. credit, liquidity)
In relation to market risk it involves subjecting a portfolio to extreme market movements by radically changing the underlying assumptions and characteristics - including changing asset class correlations and volatilities, which are often observed to increase during extreme market events.
Outline two types of stress test
Two types of tests are designed to:
1. Identify ‘weak areas’ in the portfolio and investigate the effects of localized stress situations by looking at the effect of different combinations of correlations and volatiltiies.
- Gauge the impact of major market turmoil affecting all model parameters while ensuring consistency between correlations while they are stressed
Explain what is meant by reverse stress testing
This is the combination of a severe stress scenario that only just allows the company to be able to fulfill its strategic business plan.
Equivalently, it is the scenario which would just be enough ti stop them doing so.
The scenario might be financial or non-financial.
Although it might be an extreme scenario, it must be PLAUSIBLE!!!
Describe how a stochastic model could be used to evaluate a particular risk
The variables that gives rise to the risk are treated as RVs with probability distributions.
The model must be DYNAMIC, with full interactions/correlations between variables.
The model can be run to determine the amount of capital that is needs to (just) void ruin with a given probability
Outline 3 approaches to limiting the ideal scope of a stochastic model in order to make the model more practical
- Restrict the time horizon that the model projects
- Limit the number of variables that are modelled stochastically and model the other variables deterministically with scenario testing.
- Carry out a number of runs each with a different single stochastic variable, followed by a single deterministic run using all the worst case scenarios together.
Outline how the overall capital requirement for a combination of risks relates to the individual risk capital requirements, if the risk events are:
- fully dependent
The overall capital requirement is the sum of the individual capital requirement
Outline how the overall capital requirement for a combination of risks relates to the individual risk capital requirements, if the risk events are:
- fully independent
The overall capital requirement is LESS than the sum of the individual capital requirements (the difference is the diversification benefit). Under certain assumptions, the overall capital requirement can be determined as the square root of the sum of the squares of the individual risk capital requirements.
List 3 methods of aggregating partially dependent risks
- Stochastic model
- Correlation matrix
- Copulas
Two groups of risk measures
- Deterministic: simple, gives broad indication of the level of risk
- Probabilistic: more accurate, but more complex, could lead to inappropriate levels of confidence
What are the 4 probabilistic approaches to measuring risks?
- Deviation ( std & tracking error)
- Value at risk
- Probability of ruin
- Tail Value at risk
Describe what is meant by a “risk portfolio” and what it might contain.
A risk portfolio is a means of categorizing the various risks to the company or individual. Against each risk the likely impact and probability of occurrence are recorded. The product of these measures gives an idea of the relative importance of the various risks.
The risk portfolio can be extended to indicate how each risk has been dealt with, e.g. accepted, rejected transferred or managed. Where risk has been mitigated, the risk portfolio can include a revised assessment of the remaining risk.
For retained risks, the risk portfolio could also include details of control measures, reassessment after controls, risk owners, committee/senior management with oversight, identification of concentrations of risk and the need for management in these areas.
