Module 15: Introduction to risk modelling Flashcards
5 Examples of quantifiable risks
- enterprise risk
- insurance / underwriting risk
- market / economic risks
- credit risk
- liquidity risk
Type of model used for analysing:
Enterprise risk
Dynamic Financial Analysis
and
Financial Condition Reports
Type of model used for analysing:
Insurance / underwriting risk
underwriting models or reviews
Type of model used for analysing:
market / economic risks
- VaR,
- Tail VaR,
- interest rate models,
- scenario testing
Type of model used for analysing:
credit risk
Credit risk models
Type of model used for analysing:
liquidity risk
Asset-Liability Models
4 Issues in risk quantification
- difficulties in assessing possible emerging risks and future extreme events (although EVT may be useful)
- imperfect data (eg limited volume, heterogeneity)
- difficulties in assessing the interdependence of risks (although multivariate distributions or copulas may be useful)
- how to deal with unquantifiable risks (although broad risk ranges or buckets may be used)
Correlation
A measure of how different variables relate or associate to each other:
- if risks all have high positive correlation with a given risk factor then this is evidence of risk concentration
- negative correlation implied (partially) offsetting risks
- low correlation implies (some degree of) diversification
Pearson’s rho
A measure of linear dependence between variables.
It is a function not only of the joint distribution of the variables but also of the marginal distributions.
It is only valid if the marginal distributions are jointly elliptical.
Rank correlation coefficients
Based on the positions (or ranks) of items of observed data rather than the data values themselves:
- they are independent of the marginal distributions of the variables
- take a value of zero if the random variables are independent
- take the value of 1 if the ranks are perfectly aligned (comonotonic)
- take the value of -1 if the ranks are precisely reversed (countermonotonic)
- Examples are Spearman’s rho and Kendall’s tau
Tail correlation
Focuses on the extreme values.
For example, it may be defined as the correlation based on the lowest and highest k% of observations in a sample.
Deterministic model
Uses a set (or sets) of assumptions that are pre-determined.
Under each set, each variable takes a unique value.
Deterministic models can be back-tested by using historical data and comparing the results with what actually happened.
Deterministic modelling approaches include: (3)
- sensitivity testing
- scenario analysis (with links to Business Continuity Management)
- stress testing
Stochastic modelling
Treats one or more of the assumptions as random variables.
The model is run several times (simulations) each drawn randomly from the distribution(s).
The output is a distribution of outcomes.
2 Main approaches to stochastic modelling
- Bootstrapping (generating simulations using historical data)
- Forward-looking (using Monte Carlo simulation)
Forward-looking stochastic models can be: (2)
- factor-based (modelling causal links between drivers and key variables)
- data-based (modelling key variables directly, eg time-series approach)
Dynamic Financial Analysis
Involves modelling the risks to which the enterprise as a whole is exposed and the relationships between these risks.
The outputs from these complex models is generally in the form of cashflow information used to produce projected balance sheets and profit and loss accounts.
The method of assessing a company’s capital is typically a form of dynamic financial analysis.
Financial Condition Report
A report into the current solvency position of a company and its possible future development.
This requires the company to consider the risks to which it is exposed and, in particular, involves looking at projections of the expected level and profitability of new business, including any unusual features it may have.
Define insurance risk and underwriting risk
Insurance risk relates to deviations in the timing, frequency and severity of insured events from those expected at underwriting.
Underwriting risk relates to the possible errors in the selection, approval or pricing of insurance risks.
Describe ALM in the context of modelling liquidity risk
Asset-Liability Modelling is a method of projecting both the assets and liabilities of an institution within the same model, using consistent assumptions, in order to assess how well the assets match the liabilities, and to understand the probable evolution of future cashflows.
In the context of liquidity risk, we are interested in the level of cash held in each period to ensure that short-term liabilities can continue to be met with a desired level of confidence.
Describe what is meant by the term “black swan event”
One-off events which are rare (beyond normal expectation), hard-to-predict and high-impact have come to be known as “black swan” events.
They are sometimes characterised as those events that are “predictable with hindsight”.
Outline two processes that could help us respond appropriately to rare events when they happen
To help us respond to rare large-impact events, we could:
- use previous experiences and incorporate any learning points from past events into our ERM strategy with an aim of becoming better able to react appropriately to ‘surprising’ events
- develop an emerging risks register of potential future issues.
Outline possible limitations of data upon which risk assessment is to be based
Data upon which a risk assessment is to be based might be limited in volume and/or be heterogeneous.
Alternative data sources (eg external published data) may help to reduce such problems but could introduce new issues (eg lower reliability).