Constraints Used in Managing Market Risks
Effective management of risk is highly dependent on designing suitable constraints that can be used in market risk management. Measuring VaR to a confidence level as high as 99% and placing a loose limit can be less of a constraint…
Risk Measures for Different Market Participants
Risk measures differ among market participants mainly because of the following factors: The degree to which a participant is leveraged and their need to assess minimum capitalization or maximum leverage ratios. Risks to which different businesses are exposed. The regulatory…
Advantages and Limitations of Risk Measures
The following are some of the advantages and limitations of sensitivity and scenario analysis methods of measuring risk: Advantages of Sensitivity Risk Measures In-depth analysis of dependence: Sensitivity analysis ensures an in-depth study of the independent variables (risk factors) and…
Use of Sensitivity and Scenario Risk Measures
Sensitivity Risk Measures Remember that sensitivity risk measures include beta, duration, convexity, and the option Greeks. Beta measures the sensitivity of an equity’s expected return to the equity risk premium. Duration is perhaps the most important risk measure in fixed-income…
Exposure Measures and Their Use
Equity Exposure Measures Alpha: This is a financial risk ratio used in the prediction of returns obtained from holding an investment. It measures the value created by an active fund manager or an index provider. Investors prefer a positive and…
Sensitivity and Scenario Risk Measures
Sensitivity Risk Measures Sensitivity analysis involves determining how changes in risk factors affect the value of an asset or a portfolio. This process measures the sensitivity of the value of the assets to one or more risk factors. Sensitivity analysis…
Extensions of VaR
Conditional Value at Risk (CVaR) Rockafellar and Uryasev introduced conditional value-at-risk (CVaR) in 2000. CVaR is a tail risk metric that quantifies the amount of the expected losses beyond the VaR cutoff point at a specific confidence level. It is…
Advantages and Limitations of VaR
The following are some of the advantages and limitations of the VaR. Advantages Easy to understand: VaR is a single number that approximates the amount of risk in a portfolio. VaR is presented either as a percentage of the value…
Estimating VaR
Parametric Method The parametric method obtains a VaR estimate by using the formula below: $$ VaR_p=\mu-\alpha_p\sigma $$ Where: \(VaR_p\) is the estimated VaR of portfolio \(p\). \(\mu\) is the mean of the portfolio or the expected return of the portfolio….
Methods of Estimating VaR
Parametric (Variance-Covariance) Method The parametric method is also called the variance-covariance method. This method looks at the price changes of an investment over a lookback period and computes a portfolio’s maximum loss using probability theory. It uses the standard deviation…
