Assessing the Suitable Risk Level

Heuristic Risk Measures

Heuristics are practical rules or general practices that come from experience rather than formal scientific analysis. They're not necessarily wrong, but they tend to be simple, one-size-fits-all solutions and may not align perfectly with modern portfolio theory. Examples of heuristic risk measures in portfolio construction might include setting limits on individual position sizes or industry exposure, although these limits aren't rigid.

Formal Risk Measures

In contrast, formal risk measures are precisely defined and rely on statistical, mathematical, and data-driven analysis. They are designed to provide a comprehensive understanding of portfolio risk and help manage it effectively. Here are some examples of formal risk measures:

• Conditional VaR (CVaR): This quantifies the expected loss after VaR has been exceeded.
• Incremental VaR: It calculates the marginal change in VaR when positions are added or removed from a portfolio.
• Modified VaR: Similar to VaR but doesn't assume a normal distribution of returns.

Other Notable Issues

Leverage: Leverage magnifies both gains and losses in a portfolio. Inaccurate risk estimation can lead to amplified results.

Volatility: Sudden changes in volatility can disrupt investment plans. Unexpected shifts in volatility may render risk estimates unreliable.

Portfolios with fewer positions: When a portfolio has few positions, idiosyncratic risks become more significant, making risk estimation less reliable. Concentrated portfolios are more susceptible to misestimated risks due to their unique and unpredictable idiosyncratic risks.

Question

If VaR has been breached, which metric calculates the anticipated actual loss?

1. MVaR.
2. IVaR.
3. CVaR.

Solution

The correct answer is C.

Conditional Value at Risk (CVaR) is a risk metric that calculates the anticipated actual loss beyond the Value at Risk (VaR). In other words, it measures the expected loss in the tail of the distribution when VaR is breached. CVaR provides a more comprehensive measure of risk compared to VaR because it not only quantifies the magnitude of the loss but also considers the likelihood of occurrence.

A is incorrect. Modified Value at Risk (MVaR) is not a widely recognized risk metric, and it is not commonly used in risk management. While there are variations and modifications of VaR, MVaR is not a standard or established metric for calculating anticipated actual loss when VaR is breached.

B is incorrect. Integrated Value at Risk (IVaR) is also not a widely recognized risk metric, and it is not commonly used in financial risk management. Like MVaR, IVaR is not a standard or established metric for calculating the anticipated actual loss beyond VaR.

Reading 26: Active Equity Investing: Portfolio Construction

Los 26 (e) Discuss risk measures that are incorporated in equity portfolio construction and describe how limits set on these measures affect portfolio construction