CHAPTER 3 RISK ASSESSMENT

Question 1

What is the purpose of risk assessment in a company?

Answer 1

Risk assessment: Measure, analyze, and quantify identified risks. Crucial for understanding and response strategies. Incorrect quantification can lead to unexpected losses and threats to survival.

Question 2

What is the role of risk analysis in the risk assessment process?

Answer 2

Risk analysis examines specific factors that influence the impact of a risk, known as risk factors, to understand the nature and severity of risks.

Question 3

Why is risk aggregation important in risk assessment?

Answer 3

Risk aggregation combines individual risks to determine a company’s overall risk position, providing a comprehensive understanding of the risk situation and informing risk management decisions.

Question 4

What is the challenge in risk measurement?

Answer 4

The challenge in risk measurement is to quantify potential adverse deviations of future outcomes.

Question 5

What role do moments of the random variable play in risk measurement?

Answer 5

Moments of the random variable, such as expected values or standard deviations of outcomes, are used to summarize the potential outcomes. They provide a basis for risk measurement and help in understanding the characteristics of the random variable.

Question 6

How are probabilities determined in risk measurement?

Answer 6

Probabilities can be derived from historic observations or subjective expectations. In some cases, specific probability distributions, such as the normal distribution, are assumed to describe the probabilities of the random variable.

Question 7

Are there any cases where corrections need to be applied when using sample moments as estimators?

Answer 7

Yes, in some cases, corrections need to be applied when using sample moments as estimators for population moments. These corrections ensure the accuracy and representativeness of the estimators.

Question 8

What are the advantages of using the maximum loss measure?

Answer 8

Advantages of maximum loss measure:
- Simple calculation
- Independence from unknown probability
- Useful as control value for other risk measures

Question 9

What are the disadvantages of the maximum loss measure?

Answer 9

Disadvantages of maximum loss measure:
- No probability information
- Ignores investment/capital
- Limited comparability
- Excludes other loss events
- May not exist for unlimited losses

Question 10

What are the advantages of using the expected loss and expected relative loss measures?

Answer 10

Advantages of expected loss and expected relative loss measures:
- Consideration of all loss events
- Incorporation of probabilities
- Comprehensive view of potential losses (size and probability)

Question 11

What are the disadvantages of the expected loss and expected relative loss measures?

Answer 11

Expected loss and expected relative loss measures may not accurately account for probability distribution, leading to potential distortions in risk assessment. Investment or capital is still not considered.

Question 12

What is the significance of volatility as a risk measure?

Answer 12

Volatility is a well-established measure of risk that quantifies the dispersion in outcomes. It is calculated as the square root of the variance, which captures the differences between individual outcomes and their expected value.

Question 13

How does the lower semi-deviation differ from volatility in capturing downside risk?

Answer 13

The lower semi-deviation measures downside risk, while volatility considers both positive and negative deviations. However, the standard deviation is more commonly used than the lower semi-deviation.

Question 14

What are some of the limitations of using volatility as a risk measure?

Answer 14

• Observation period affects volatility results.
• Volatility represents risk with both positive and negative deviations.
• Comparing volatilities is challenging for different holding periods.
• Volatility does not express risk in specific currency values.
• Risk measurement is independent of the decision-maker’s attitude.

Question 15

How can VaR be defined and what does it represent?

Answer 15

VaR measures potential losses of an asset position with a given confidence level, representing the worst loss that will not be exceeded. It focuses on downside risk.

Question 16

Besides market risk, in what other areas can VaR be applied?

Answer 16

VaR can also be applied to other risks such as credit risk (Credit Value at Risk), operational risk (Cash Flow at Risk), and business risk (Operational Value at Risk).

Question 17

What are the main objectives of using VaR?

Answer 17

-Measure risk in monetary units.
-Provide a risk measure that allows for comparisons between different types of risks.
-Facilitate the aggregation of various types of risks.
-Consider the liquidity of asset positions.

Question 18

What is the definition of Value at Risk (VaR)?

Answer 18

Value at Risk (VaR) is the maximum expected loss that can occur over a specific holding period, with a confidence level determined by the decision maker.

Question 19

Influence of Determinants: How do the determinants affect VaR?

Answer 19

Each determinant, including the risk position, volatility, holding period, and confidence level, has a positive influence on VaR. As these determinants increase, VaR tends to increase as well.

Question 20

Incorporation of Risk Attitude: How does the decision maker’s risk attitude impact VaR estimation?

Answer 20

Risk attitude in VaR:
- Reflected through confidence level choice
- Higher confidence level indicates more risk aversion
and Results in higher VaR

Question 21

Normal Distribution Assumption: What is the potential issue with the normal distribution assumption in VaR?

Answer 21

The assumption of a normal distribution can be problematic because financial returns often exhibit non-normal behavior, such as skewness or fat tails, which deviate from the normal distribution assumption.