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 markets. It represents the linear sensitivity of the bond rate of return to movements in yields. Convexity is the quadratic effect.

The option Greeks measure the sensitivity of the value of an option to a small change in each underlying parameter. This allows the components of the risk to be treated in isolation. The Greek letters are reasonably easy to calculate. This makes it convenient for options traders to hedge their positions against undesirable changes in the market.

Risk managers, therefore, use these sensitivity measures to understand and measure how portfolio positions react to the underlying sources of risk. Sensitivity risk measures differ from VaR in that they do not tell us anything about the likelihood of occurrence of a given change in value.

Scenario Risk Measures

Scenario risk measures differ from sensitivity risk measures since they use various risk factors. Besides, factor movements are larger relative to the single factor movements that sensitivity risk measures employ.

Scenario risk measures pay attention to extreme outcomes. Stress testing is a scenario risk measure that quantifies the impact of extreme negative stress on a portfolio.

Historical scenarios refer to events that have taken place and may recur in the future. Price histories can be used as proxies to model equity positions. On the other hand, hypothetical events have never occurred in the past and, as such, are not grounded in previously observed dynamics. They model the impact of extreme movements in different markets.

Reverse stress testing refers to the exploration of tail risks (most significant exposures). The aim of this exploration is to uncover hidden vulnerabilities and scenarios that are not reflected in the conventional stress testing analysis. Reverse stress testing enables risk managers to understand and focus their attention on the areas of weakness that could potentially be harmful to an organization.

In conclusion, scenario analysis is useful in the isolation and management of operational risks. The past several years have seen the financial industry suffer many tail events resulting in extensive financial loss or even reputation damage. Scenario analysis is instrumental in the risk management process. Studying past risk events lays ground upon which their recurrence is averted.

Question

Which of the following is most likely applicable in extreme negative stress to a portfolio exposure?

1. Stress tests
2. Reverse stress tests
3. Sensitivity analysis

Solution

The correct answer is A. 

Stress tests are scenario risk measures that focus on quantifying the impact of extreme negative stress on a portfolio.

B is incorrect. Reverse stress testing involves identifying a portfolio’s significant risk exposures and then determining an unacceptable outcome, that is, the one that would have a severe impact on an organization. This is followed by the identification of different scenarios of risk factors that would result in an unacceptable outcome.

C is incorrect. Sensitivity analysis involves examining how the performance of a portfolio reacts to a single change in an underlying risk factor.

Reading 41: Measuring and Managing Market Risk

LOS 41 (h) Describe the use of sensitivity risk measures and scenario risk measures.