Chapter 3 - Measuring risk Flashcards
What two risks does risk management focus on
- credit risk
2. market risk
What are some measures of risk
- Standard deviation
- VAR
- Beta
How does standard deviation express risk
- The amount of historical volatility associated with an investment relative to its annual rate of return
- indicates how current rates deviate from its expected historical rate
How does Beta express risk
measures the amount of systematic risk that a single security or industry sector has relative to that of the market
What are the key characteristics and functions of VAR
- provides a summary of market risk
- measures worst expected returns over a given time interval under normal market conditions at certain confidence levels
- Single aggregate risk measure applicable in many situations
- statistical measure used to assess level of risk associated with a portfolio or company
- gives the expected loss during a specified time period, at a stated probability (mostly 1% or 5%)
- always has a dual interpretation
What are the different methods to calculate VAR
- Analytical VAR method
- Historical VAR method
- Monte Carlo VAR method
What is the analytical risk formula
VAR = (Rp-[Z]sigma)Vp
1% VAR - 2.33 SD below mean
5% VAR - 1.65 SD below mean
What are the advantages of VAR
- Summarizes all risk associated with an organization’s portfolio into a single number
- Consistently measure risk across all an organization’s trading activities
- Can be employed to compare large varieties of financial instruments and portfolios
- Considers interrelationships between different risk factors
- Can be measured in units as well as a percentage of portfolio value
- Embedded in financial software
- Recognized by regulators
What are the disadvantages of VAR
- Different computation methods can present different estimates of VAR
- It can generate a false sense of hope (only as good as the input and estimation process)
- It is one-sided, focusing on the left tail in the returns distribution and ignores any upside potential
List the various methods/approaches of measuring risk-adjusted performance
- Sharpe ratio
- Risk-adjusted returns on invested capital (RAROC)
- Return on maximum drawdown (RoMAD)
- Sortino ratio
What does Sharpe’s ratio measure
Excess returns over the risk-free rate per unit of risk
(Rp-Rf)/SD
The measure of risk is SD
How is Risk adjusted returns on invested capital (RAROC) calculated
Calculated as the ratio of the expected return of the portfolio to some measure of risk, eg VAR
How is the return over maximum draw down calculated
The annual return rate divided by the portfolio’s maximum drawdown
RoMAD = Rp/(Maximum Drawdown)
What is Sortino Ratio
It is the ratio of the excess return to risk
Where excess return is the portfolio return less the minimum acceptable portfolio return (MAR). The denominator is the SD of returns calculated on using only returns below MAR
Why are only downside returns used in the Sortino calculation
High returns will unfairly inflate the volatility measure
