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

1. In-depth analysis of dependence: Sensitivity analysis ensures an in-depth study of the independent variables (risk factors) and dependent variables (asset returns). It involves an analysis of their movements as well as interdependence, including the effect of reaction between the two, therefore, obtaining more accurate forecasts.
2. Ensures proper investment decisions: Sensitivity analysis helps to forecast future returns using historical data. By analyzing all the appropriate variables and potential outcomes, critical industry-specific and economy-based decisions are made. These decisions are the premises upon which the best investment decisions are made.

Limitations of Sensitivity Risk Measures

1. Based on assumptions: Sensitivity analysis is based on management assumptions since it mostly uses historical data. Logically, therefore, wrong assumptions lead to inaccurate forecasts.
2. Ignores the correlation between variables: Sensitivity analysis estimates an outcome by considering individual variables. However, in the real market, some variables may be interrelated. For example, sensitivity analysis considers the impact of factors such as inflation and fluctuation of the market interest on the bond price, on an independent basis. It does not consider the possibility of an interrelation between inflation and the market interest rate.

Scenario Risk Measures

Advantages

1. Helps improve systems thinking: A manager can predict the potential outcomes, both positive and negative, that may result from using particular strategies and policies. Such predictions are guided by scenario risk measures.
2. Ensures optimal allocation of resources: Scenario analysis helps to make forecasts of events. This enhances managers’ awareness of how external conditions may potentially affect normal business operations. This helps them in the allocation of resources in a more effective way to avoid undesirable adverse effects.
3. Avoids risk and failure: By assessing the prospects of an investment, scenario analysis helps investors and businesses avoid making poor investment decisions. It helps investors make informed decisions by taking the best and worst scenarios into account.

Limitations

1. Unexpected and unfavorable outcomes: Scenario analysis is too demanding, time-consuming, and requires a high level of expertise. These challenges compromise the accuracy of forecasts. Scenario analysts, therefore, end up with unexpected and unfavorable actual outcomes.
2. Unrealistic: It is difficult to visualize all possible scenarios and allocate them probabilities. Historical scenarios, for example, happen differently any time they occur.

Question

Which of the following is least likely a limitation of sensitivity risk measures?

1. They omit variable correlations.
2. They assume a normal distribution of the market returns.
3. It is challenging to identify all possible scenarios and allocate probabilities.

Solution

The correct answer is C. 

This is a limitation of scenario risk measures. It is almost impossible to visualize all the possible future scenarios and assign probabilities.

A is incorrect. Sensitivity analysis estimates an outcome by considering individual variables. However, in the real market, some variables may be interrelated. For example, sensitivity analysis considers the impact of factors such as inflation and fluctuation of the market interest on the bond price, on an independent basis. It does not consider the possibility of interrelation between inflation and the market interest rate. This, obviously, is a disadvantage.

B is incorrect. The outcomes of scenario risk measures are all based on assumptions because the variables are based on historical data. This means it is not accurate, so errors may arise when applying the analysis to future predictions.

Reading 41: Measuring and Managing Market Risk

LOS 41 (i) Describe the advantages and limitations of sensitivity risk measures and scenario risk measures.