Chapter 4: Risk measurement Flashcards
Skewness
Third central moment
Measures the extent to which a distribution is symmetric about its mean
Kurtosis
Fourth central moment
Measures how likely extreme events are to occur
What question does variance answer
How widely dispersed are the possible outcomes?
What question does downside semi-variance answer
how widely dispersed are the unfavourable outcomes
Shortfall probabilities
Measures the probability of returns falling below a certain level
What question does expected shortfall answer ?
what is the expected loss (below my target)
Value At Risk
- The maximum potential loss
- In value
- on a portfolio
- Given a future time period
- with a givn degree of confidence
Advantages of using variance as a risk measure
- Mathematically tractable
- Provides elegant solutions for optimal portfolios
- Gives good approximation of other methods
- Leads to optimal portfolios for quadratic utility functions
- or if returns are assumed to be normally distributed
Arguments against variance solved by downside semi-variance
- Investors do not dislike uncertainty, rather they dislike the possibility of low returns
Advantage of shortfall probabilities
Easy to understand and calculate
Disadvantage of shortfall probabilities
It gives no indication of the magnitude of any shortfall
Disadvantage of using VaR
- Assumes that returns are normally distributed
- It does not quantify the size of the tail
In what cases would portfolios exhibit non-normal returns
- Credit risk
- Systematic bias
- Derivatives
What is the usefulness of shortfall measures in general
Monitoring a fund’s exposure to risk as the expected underperformance relative to a benchmark is easier to understand
Broad disadvantage of shortfall measures
No attention to outperformance of benchmark
