FIN 443 Enterprise Risk Management: Module 4 Study Guide Questions
What is Warren Buffet's famous quote about derivatives?
"Derivatives are being used as financial weapons of mass destruction
What does "risk of ruin" mean?
"Risk of Ruin" is the likelihood that the company cannot meet its liabilities over a specified time horizon.
What is stress testing a type of?
"Stress testing" is a type of "scenario analysis."
What is the statistical term for Black Swan?
"fat tails."
Put option? Call option?
A put option, which gives you the right to sell the stock at a specific price.
What are the two main reasons that an economic capital model suits ERM?
1.Economic capital links risk and return explicitly. 2. Economic capital provides a common currency for risk, which allows risks to be compared across different business units in the organization.
What are four reasons that VaR is very popular at financial institutions
1.VaR can be used to rate the risk of a portfolio that consists of equities, bonds, and derivatives or all of these in a portfolio. It's the only commonly used risk measure that can be applied to just about any asset class. 2.VaR takes into account a head-spinning variety of variables, including diversification (which decreases market risk) and leverage and volatility (which increases market risk), that make up the kind of market risk that traders and firms face every day. 3.VaR can measure not only individual risks — for example, the amount of risk contained in a single trader's portfolio — but also firm-wide risk. It does this by combining the VaRs of a given firm's trading desks and coming up with a net number. Top executives usually know their firm's daily VaR within minutes of the market's close. 4.VaR boils risk down to one number, which is easy to understand by executives.
What are the assets of an insurance company
? Assets are the investments made by the insurer.
What does Black Swan mean about events?
A "Black Swan" basically means an event that we think is very unlikely, but that occurs more often than we think. In statistical term, the term for black swans is "fat tails." What does that mean? It means that risks often follow a probability distribution that has thicker tails than a normal distribution. This is called "tail risk." Taleb is convinced that so-called extreme events take place far more frequently than most human beings are willing to contemplate.
What does "basis point" mean?
A "basis point" is typically used for interest rates, and means one hundredth of a percent (0.01%). So 200 basis points is 2%.
What is a common method for calculating economic capital using stress tests?
A common method to calculate Economic Capital is called the "market-consistent balance sheet approach."
When is a company most efficient?
A company is most efficient when it is in that sweet spot of holding capital that we saw at the beginning of the semester. Not too little and not too much capital.
What is a likely cause of more frequent disasters?
A complex, interconnected world is likely a cause of more frequent disasters.
What is a credit loss distribution of a bank?
A credit loss distribution for a bank is a probability distribution graph with potential losses from borrowers not paying back loans on the X axis and the likelihood (probability) of losses occurring on the Y axis. In other words, this is a probability distribution for the bank on the likelihood of losses from its loan portfolio, meaning losses from borrowers not playing back loans from the bank.
What is an important lesson for risk management related to VaR?
A important lesson for risk management related to VaR is that you have to be very careful about the distribution that you assume
After stress tests are applied, economic capital is measured as the difference in "market-consistent net assets" between what conditions?
After stress tests are applied, Economic Capital is measured as the difference in "market-consistent net assets" between normal conditions and stressed conditions as shown in the accompanying figure.
When can a company hold less capital? What is the risk of an integrated portfolio of risks less than?
All of this means that a company can hold less capital if it considers its risks in a portfolio and if it understands the correlations between the risks. This is the concept of economic capital, introduced previously. Remember that the risk of the integrated portfolio of risks is less than the weighted average of individual risks. Let's look more at the natural hedge and hedging net risk concepts.
What is an important Modern Portfolio Theory (MPT) concept for ERM?
An important MPT concept for ERM purposes is the "diversification benefit of holding a diversified portfolio." The expected return of a portfolio of securities: The basic idea is that you don't lose any return when holding a portfolio of securities. That is, the expected return of the portfolio is just the weighted average of the expected returns of the individual securities. Risk of a portfolio of securities: The basic idea is that risk of the portfolio is less than the sum of the individual risks of the securities in the portfolio.
Why isn't economic capital assigned for a company's "expected loss"?
Because the bank should have already priced that in, meaning charged interest rates to reflect the riskiness of borrowers.
Who did they join with and what was name of company they created?
Black died, but the other two guys (Merton and Scholes) got the Nobel Prize in1997 for their work on option pricing. In the 1990s, Scholes and Merton later joined a company known as Long-Term Capital Management. The guys who developed the option pricing model were well-respected. However, in the 1990s they joined big name Wall Street traders to create a company, Long-Term Capital Management (LTCM).
Broadly speaking, what does stress testing assess?
Broadly speaking, stress testing assesses the potential impact of historical or hypothetical events or specific movements in risk factors on a given portfolio.
What are these agencies building economic models into?
Building economic models into their rating process during ERM reviews
What do business units that take more risk have to do?
Business units that take more risk have to generate higher returns to compensate for the higher economic capital charge.
What are two commonly used confidence intervals for VaR? Value at Risk (VAR) is defined as the maximum loss not exceeded with a given probability (defined as the confidence level) over a given period of time.
Commonly used confidence levels are 95% and 99%.
What should companies do instead of hedging risks separately? What is more efficient to hedge?
Companies should not hedge risks separately but only hedge the residual risk. It's much more efficient to hedge the net risk, that is, the residual risk, of the portfolio than it is to hedge each individual risk.
In Step 4 to calculate economic capital, what is considered when aggregating the economic capital required for each risk category?
Correlation
What are derivatives?
Derivatives are the general term for options and other instruments that can be used to hedge financial risk.
What big problem were they at the heart of causing?
Derivatives, such as credit default swaps, were also at the heart of the big 2008 crash
How does ERM consider risks?
ERM considers risks in a portfolio, not individually, that is, not in silos
What view does ERM have?
ERM, which has a portfolio view of risks, not a silo view.
What are economic capital charges applied to and based on what?
Economic capital charges are assigned to specific business units (lines of business) based on risks.
What is economic capital in terms of "unexpected losses".
Economic capital is the amount of capital that the firm must set aside to cover against unexpected losses (UL).
What is economic capital?
Economic capital is the amount of risk capital that a firm estimates is required to cover the unexpected losses arising from risk exposures.
What does economic capital provide and what does this allow to be compared?
Economic capital provides a common currency for risk, which allows risks to be compared across different business units in the organization
What does economic capital achieve in allocating capital to different parts of the firm?
Effective for allocating capital to different parts of the firm to achieve the highest risk-adjusted return.
What does less correlation between risk categories result in?
Less correlation between risk categories in a portfolio results in a greater diversification benefit.
How does ERM generalize the MPT concept
Enterprise risk management (ERM) generalizes Modern Portfolio Theory (MPT) concepts beyond risks of securities to include risks of all kinds, i.e., beyond a portfolio of equity investments to the entire collection of risks an organization faces. ERM borrows these four general principles from modern portfolio theory. 1.When you consider risks in a portfolio, instead of individually in silos, you need to understand the correlation (interrelation) between risks. 2.When considering risks in a portfolio, most risks are not 100% correlated, which gives you a diversification benefit. Even better is that some risks will actually offset each other, which are called natural hedges. The diversification benefit of MPT pays off the most when you to find natural hedges. 3.Companies should not hedge risks separately but only hedge the residual risk. It's much more efficient to hedge the net risk, that is, the residual risk, of the portfolio than it is to hedge each individual risk. 4.All of this means that a company can hold less capital if it considers its risks in a portfolio and if it understands the correlations between the risks. This is the concept of economic capital, introduced previously. Remember that the risk of the integrated portfolio of risks is less than the weighted average of individual risks. Let's look more at the natural hedge and hedging net risk concepts.
What are risks called that actually offset each other? When does the diversification benefit of MPT pay off the most?
Even better is that some risks will actually offset each other, which are called natural hedges. The diversification benefit of MPT pays off the most when you to find natural hedges.
What were derivatives developed for? But how have they been used that periodically results in worldwide financial panics?
Even though derivatives were developed for managing financial risk, when used in the wrong way, such as for speculation, they periodically appear to cause worldwide financial panics.
What are examples of stress tests?
Examples of stress tests are equivalent risk of ruin over one year, equity price, and fixed interest yield, and there is a level for each of these stress tests that will be applied in the next step depending on the company's target financial strength rating.
What are these agencies expecting companies to demonstrate?
Expecting companies to demonstrate balance between qualitative and quantitative ERM
What discipline did Finance branch off from in the 1950s? Why?
Finance was originally part of the Economics discipline, but started to branch off as a separate discipline in the early 1950s.
When does tail risk become very low for a normal distribution?
For a normal distribution, tail risk is low, meaning that the likelihood of a large loss becomes almost zero when you get a few standard deviations from the mean.
Where does Moodys get the percentages related to its ratings?
From historical data. In this case, Moody's used data from 1920 to 2005 (historical data) to see how ratings changed over a year period. For example, over this time they found that, out of all firms with an Aa rating, only 0.06% defaulted within a year.
What does greater standard deviation of returns mean about returns?
Greater standard deviation means that the returns are more volatile, meaning there is more uncertainty about the stock and thus is more risky.
What are these agencies linking capital adequacy requirements directly to?
Linking capital adequacy requirements directly to ratings
In other words, what determines how much less the standard deviation (risk) of the portfolio expected return is than the weighted average of the standard deviations (risk) of the returns of individual securities?
How much less depends on correlation between the individual returns. The less correlated the returns of the individual stocks are, the less the standard deviation of the expected return of the portfolio is than the weighted average of the SDs of the individual securities.
What are the four theoretical models from the academic finance literature that are the basis of modern Finance?
However, the 1952 breakthrough paper on modern portfolio theory by Markowitz earned him the Nobel Prize. The other academics listed here also received Nobel Prizes for their work. Together, I am calling these four models the "Basis of Modern Finance." Modern Portfolio Theory (Markowitz,1952) Theory of Corporate Finance (Modigliani and Miller, 1958) Capital Asset Pricing Model: CAPM (Sharpe, 1964 and Lintner, 1965) Option Pricing Model (Black and Scholes, Merton, 1973)
In Step 2 to calculate economic capital, what is used to determine the company's key risks and at what level?
Identify key risks, target financial strength ratings, and determine levels of stress to be applied To calculate Economic Capital, the firm needs to identify its key risks.
How do insurers typically hedge the risk of their insurance portfolios?
If a person has both a life insurance and an annuity policy, and dies soon, the insurer loses on the life insurance and gains on the annuity, and vice versa if the person lives long. These two types of coverage are a natural hedge for the insurer.
When are the standard deviations equal?
If expected returns of the individual securities are 100% correlated, the equation uses an = sign.
What determines whether = or < is used in the above formula?
If expected returns of the individual securities are 100% correlated, the equation uses an = sign. If expected returns of the individual securities are less than 100% correlated, the equation uses a < sign.
It is unlikely that risks facing a company are 100% correlated. What is an example?
If the risks are considered in a portfolio, and you know the correlations between the risks, total risk is less if the risks are not 100% correlated. It's unlikely risks facing a company are 100% correlated. For example, there is probably little correlation between the company's property being destroyed by hurricane and a new competitor for the company emerging.
If you don't know the correlations between the risks facing your company, what do you have to assume about all the risks and how does that affect the amount of capital your company needs to hold?
If you don't know the correlations between the risks, you have to basically assume that all the risks are 100% correlated, which is the worst case.
In general, what is an option?
In general, options give the right (option) for the option holder to buy (or sell) a security at a pre-arranged price for a pre-arranged amount of time. For example, I own Microsoft (MSFT) stock and current price is $25/share. I purchase an option from you that gives me the right to sell you my shares of MSFT at $20/share for the next three months.
In mathematic terms?
In mathematical terms, natural hedges are risks that are negatively correlated. In other words, if one risk increases, the other risk decreases, and vice versa. Natural hedges reduce the risk of a portfolio.
In other words, what kind of tails does a normal distribution have?
In other words, the normal distribution has "thin tails."
What is another way of stating "$50 million VAR with 99% confidence over a week".
In other words, there is a 99 percent chance that the portfolio won't lose more than $50 million during the next week. It is only meant to describe what happens 99 percent of the time.
What risk category is probably not correlated with the other risk categories and what is an example?
Insurance risk is not correlated with the other risks. For example, loss correlation between a building burning and the stock market going down is basically zero. Less correlation between risk categories in a portfolio results in a greater diversification benefit.
What are "once-in-a-lifetime disasters" happening every few year an indication of and the world we live in?
Is an indication that we are no longer living in a world of normally-distributed disasters, but seem to be living in a fat-tailed world.
What is QQQ (also known as "Cubes")?
It is the stock symbol for NASDAQ index. Think of buying QQQ as an investment in all the stocks that trade on the NASDAQ exchange.
If a company has a Moodys Aa rating, what does Moodys have 99.94% confidence about?
It means that Moodys has 99.94% confidence that the company will not become insolvent over a one-year time horizon. Or stated another way, Moodys thinks there is only a 0.06% chance that a company it rates Aa will become insolvent within the next year.
What is tail risk?
It means that risks often follow a probability distribution that has thicker tails than a normal distribution. This is called "tail risk."
What do VaR statements mean, such as the statement, "$50M VaR with 99% confidence over a week"?
It means there is a 99% chance that the portfolio won't lose more than $50 million during the next week
What is the market value of a liability
It means, how much you would have to pay someone to transfer the liability to them, for example to transfer policies to another insurance company.
Before Markowitz, how was risk considered in judging a stock's return?
It seems amazing now, but risk was not considered important. People knew that stocks were riskier than bonds, and some stocks were riskier than others, but there was no quantitative measure of the difference.
How does stress testing work and what are stress tests often based on?
It works by You basically just assume that something negative happens, then analyze how it affects your organization. Often, stress tests are based on historical events or various other scenarios, such as what happens to a firm if: Market crashes by more than x% this year? Interest rates go up by at least y% in the next two years? Unemployment stays above 10% for 2 consecutive years. Oil prices rise by 200% this year. GDP is negative for 2 consecutive years. House prices decline more than 10% for 2 consecutive years.
What type of risk can Modern Portfolio Theory (MPT) reduce?
MPT is a way to reduce investment risk.
What does MPT originally consider the risk of?
MPT originally considers the risk of a portfolio of securities, such as stocks, but we can generalize to think about a portfolio of all the risks faced by a company
What risk concept did MPT provide and what was the benefit ofa portfolio of securities?
MPT provided the Portfolio View of Risk concept of an investment portfolio and the diversification benefit of a portfolio of securities.
Why was Modern Portfolio Theory (MPT) ignored until the mid-1970s, which was 20 years after Markowitz proposed it?
MPT was mainly ignored by practitioners until the mid-1970s. Why? From 1952 until the mid-1970s, the stock market mainly went up, so it was not obvious why Portfolio Theory was important. A major recession happened in 1973-1974 and stock prices fell sharply and became volatile. This caused investors to start looking at MPT as a way to manage investment risk. Markowitz was awarded the Nobel Prize in Economics in 1990
What does market value mean?
Market value means the current value externally determined by a market. For an asset, the "market value" is the actual value you could get if you tried to sell the asset
What did Markowitz propose as a measure of risk? After Markowitz, how was the risk of a security measured?
Markowitz proposed the standard deviation of a security's return over time as a quantitative measure of the security's risk.
What did the dissertation advisor of Markowitz think and say about his work in Portfolio Selection?
Milton Friedman was a professor on his dissertation committee. Friedman became a noted economist and won the Nobel Prize in 1976. However, Friedman did not think much of Markowitz's work in Portfolio Selection and directly said that it was not economics. So Finance started to branch off from Economics as a separate discipline as described previously.
What theory basically gave rise to modern finance?
Modern Portfolio Theory (MPT) was introduced in the 1950s and basically gave rise to modern finance.
What is often used for the simulation part of the VaR calculation
Monte Carlo simulation is often used for the simulation part of VaR.
What does standard deviation tell us about estimates, for example, our estimates of expected stock returns?
One important concept mentioned earlier is that Markowitz used the standard deviation as a measure of risk. Standard deviation tells us something about the uncertainty of our estimates, for example, about our estimates of stock returns. Standard deviation is a volatility measure.
How is it different from a normal distribution?
One way a lognormal distribution is different from a normal distribution is that the lognormal distribution is skewed meaning not symmetrical.
How long have options been around?
Options have been around for centuries. An option story from 500 BC Thales of Miletus The first documented use of options was by Aristotle telling the story of a poor philosopher named Thales.
What is often a better model of how the world actually works?
Over the last couple of decades, that has been a bad assumption. The big issue is that VaR assumes a normal distribution, which has thin tails, meaning that a normal distribution predicts that what is in the tails almost never happens, whereas, in reality, fat tails are often a better model of how the world actually works. Looking at the red bars in the figure, you can see they indicate a higher probability than a normal distribution predicts.
What are the liabilities of an insurance company?
Policies are liabilities for an insurance company because the insurer will have to pay claims when the policyholders have insurable losses.
What is the basic idea about the risk of a portfolio of securities?
Risk of a portfolio of securities: The basic idea is that risk of the portfolio is less than the sum of the individual risks of the securities in the portfolio.
What are natural hedges?
Risks that offset each other are called natural hedges
What concept and ERM benefit does this illustrate?
This illustrates the diversification benefit concept of Modern Portfolio Theory (MPT) and the benefit of viewing risks in portfolios that is so crucial to ERM.
What are the four steps of the most common method used to calculate economic capital?
Step 1: Develop an economic view of the business Step 2: Identify key risks, target financial strength ratings, and determine levels of stress to be applied Step 3: Apply stresses to the economic balance sheet Step 4: Aggregate Economic Capital required for each risk category, considering correlation between risks
What are three reasons the real world started using the BSOPM immediately?
Stocks were volatile in the 1970s compared to previous decades. The Chicago Board Options Exchange opened just after this paper came out, and soon billions of options were trading. Also, another technology came out at the same time that traders adopted: the first programmable handheld calculators. Traders programmed BSOPM option pricing equations into the calculator and could calculate option prices at the touch of button.
What does stress testing evaluate that VaR may not capture?
Stress testing evaluates the risks that VaR may not capture, such as events with a very low probability of occurrence, but that would have a significant impact for the firm
What is stress testing commonly used by Standard and Poor (S&P) to assess?
Stress testing is also commonly used by Standard & Poor's analysts in assessing the risk management practices of financial institutions.
What is stress testing commonly used to calculate?
Stress testing is commonly used in the calculation of "economic capital", as we will see later.
Where is stress testing concerned with what is happening, and what is this region called?
Stress testing is concerned with what is happening out in the tails, which is called the stress region (also known as the tail region) meaning the tails of the probability distribution.
What is one way of handling this tail problem?
Stress testing is one way of handling this tail problem, as we will see later.
How does stress testing over come the tail risk problem of VaR?
Stress testing overcomes the tail risk problem of VaR.
What does the author of the Black Swan think about so-called extreme events?
Take place far more frequently than most human beings are willing to contemplate.
How did this person use options to make money?
Thales predicted from observing the stars that there would be a great olive harvest. If so, there would be a great demand for olive presses to make olive oil. But he didn't have enough money to buy a bunch of olive presses. He found someone who owned olive presses that would sell him the option of renting the olive presses for the season. Thales paid a small amount to have the right, that is the option, to rent the olive presses at a certain price during the olive harvest season. He didn't have to rent the presses when the time comes, but had the option to rent the presses. If he decided not to rent, he only lost the money he had paid for the option. But he did not have to pay the rental price. It turned out there was a huge olive harvest, so Thales exercised his option and rented the olive presses from the owner for the agreed amount. There was such a huge demand that he could then rent the presses to the olive growers for much more than he paid to rent the presses. And he made some good profits.
What can this be disastrous for?
That can be disastrous for managing risks, and it is a reason.
Unlike for VaR, what does not need to be assigned or assumed for stress testing?
That the risks are in the tails of the graph (the problem of assuming a normal distribution).
What is the big risk for an insurer that sells life insurance
That too many policyholders will die earlier than expected.
What is the big risk for an insurer that sells annuities?
That too many policyholders will live longer than expected.
The BSOPM is a risk management tool that was quickly adopted to manage what types of risks? What is the BSOPM's counterpart for managing pure risks?
The BSOPM is a risk management tool that was quickly adopted to manage financial risks. A counterpart for insurance which is used for managing pure risks.
What does Value at Risk (VaR) tell you about what is happening in the tail of the distribution?
The VaR statement tells you nothing about what could happen the other 1% of the time, that is what happens in the tail of the distribution.
If the four risk categories are not 100% correlated, how does the aggregate capital required for the portfolio of risks compare to sum of capital required for all individual risk categories?
The aggregate capital required for the portfolio of risks is less than the capital that is required for the sum of all individual risk categories.
In simple terms, what is the "diversification benefit" of Modern Portfolio Theory (MPT) for a company?
The bottom line is that by considering risks in portfolios, and by understanding correlations between risks, the company can justify holding less capital if the risks are not 100% correlated.
What does "target financial strength rating" mean?
The company would pick a "target financial strength rating",Meaning a credit rating from a rating agency, such a Moodys, that we discussed before. This the credit rating the company wants to maintain after being subject to various stress tests.
What is the basic idea about return when holding a portfolio of securities?
The expected return of a portfolio of securities: The basic idea is that you don't lose any return when holding a portfolio of securities. That is, the expected return of the portfolio is just the weighted average of the expected returns of the individual securities.
What type of allocation is VaR useful for?
The failures of VaR and the need to use stress testing.
Who was involved in the first documented use of options?
The first documented use of options was by Aristotle telling the story of a poor philosopher named Thales
In the ERM context, what does economic capital mean?
The limitation of assuming a normal distribution in the world of financial markets
In a normal distribution, where are outcomes very unlikely?
The normal distribution is handy, but it presents some problems for risk management. In a normal distribution, outcomes three or four standard deviations from the mean (meaning in the tails) are very unlikely. In other words, a normal distribution has thin tails.
What does the normal distribution predict about the likelihood of some extreme events?
The normal distribution predicts that the likelihood of some extreme events is much lower than it actually is.
Call option?
The other type of option that gives you the right to buy a stock at a certain price is called a call option.
What is the overall MPT concept about a portfolio of securities?
The overall MPT concept about a portfolio of securities is that you don't lose any return, but you reduce the risk. Same return but lower risk
What is the reason that stress testing became an alternative or a complement to Value at Risk (VaR)?
The problem with fat tail versus normal distribution is the reason that stress testing has become an alternative or a complement to Value at Risk (VaR).
What is the riskiness of a business unit related to and how is this measured?
The riskiness of a business unit is related to the volatility of the firm's profits. Firms with more volatile profits are riskier. Volatility can be measured by the standard deviation of profits over a certain time periods.
In Step 3 to calculate economic capital, what is applied for each risk category?
The stress tests are applied for each risk category, calibrated to a probability level over a one-year time horizon, consistent with the company's financial strength rating.
What is the worry about fat tails?
The worry about fat tails is that big losses are more likely than they would be under a normal distribution.
What are the five variables needed to price an option using the Black-Scholes Option Pricing model (BSOPM)? Note: you do not need to know the actual formulas.
They determined that price of a call option, C, depends on these five variables: S = price of the underlying stock K = option exercise price (strike price) r = risk-free interest rate (represents opportunity cost) T = current time until option expiration σ =standard deviation of stock return (riskiness of stock)
When does VaR work well, and when does it fail? What is the airbag analogy?
They liken it to an air bag that works all the time except when you have a car accident. In other words, it works well during normal times, but it fails miserably during bad times.
How did they try to apply the model and what was the result?
They tried to apply the model to what they thought was a way to invest worldwide and make profits almost risk-free. They become overconfident and arrogant in applying the model, had some bad luck, almost crashed the world economy, and had to be bailed out.
What is the main argument that the author of the Black Swan has against VaR? What is a Black Swan? In other words, the normal distribution has "thin tails."
This problem has been especially highlighted by Nassim Nicholas Taleb, the best-selling author of "The Black Swan," who has crusaded against VaR for years. His main argument against VaR is that it does not account for rare events that a firm never even considered as a possibility, which Taleb named "Black Swans."
What is the worst case for correlations among risks that your company faces?
To basically assume that all the risks are 100% correlated, which is the worst case
How is correlation between the four main risk categories determined?
Typically using historical data or expert judgment.
Until recently, how have options been priced?
Until recently, prices were determined by gut/intuition instead of mathematically based on theory
In the 1970s, what other type of risk did it suddenly become possible to manage? What was the reason this became possible?
Until the 1970s, companies only managed hazard risks. But then in the 1970s, it suddenly became possible to also manage financial risks. And the reason for that was because of the BSOPM (Black-Scholes Option Pricing Model (BSOPM) introduced by Black, Scholes, and Merton in 1973.).
What is the definition of VaR?
Value at Risk (VaR) is commonly used by security houses or investment banks to measure the market risk of their asset portfolios, although VaR is a very general concept that has broad applications.
By assuming a normal distribution, what does VaR imply about the tails of the distribution?
VaR assumes a normal distribution, which implies the tails are too low probability to worry about.
What kind of probability distribution does VaR assume?
VaR assumes a normal probability distribution. Why is that a problem? For a normal distribution, the likelihood of large losses is very small, meaning that probability is very low at either end (tails) of a normal distribution.
Who does VaR create a false sense of security among?
VaR can create a false sense of security among senior managers and watchdogs
What does Value at Risk (VaR) not capture and what does it say nothing about?
VaR does not capture tail risk. It says nothing about what the worst case loss might be.
In which region is VaR concerned with what is happening?
VaR is concerned with what is happening in the normal region.
What is the problem with VaR being based on past data? What are two examples where this can especially be a problem?
VaR is only concerned with what is going on in the green area, not in the red tail area. With VaR, you really don't know what is going on in the tail of the distribution.
When did VaR with its normal distribution assumption fail so miserably?
VaR with its normal distribution assumption failed so miserably during the 2008 financial meltdown
How is VaR often calculated?
VaR, which is often calculated by simulation using historical data and multiple random trials to generate outcomes.
What does stress testing not consider and what does it assume?
While VAR does not tell you anything about the tail risk, stress testing does not consider likelihood. Stress testing just assumes that an outlier (tail) event occurs and tries to understand how it will affect the company.
In essence, what is the diversification benefit of a portfolio?
You get the same expected return as considering securities individually, but if you understand the correlations between securities in your portfolio, you will find that you have less risk than when considering the securities individually.
What is a big thing that Moodys looks at in determining ratings?
a big thing that Moody's looks at in determining ratings is the amount of capital the company has to back its risks.
By aggregating risks and considering correlation between risks, what may a company be able to do?
a firm may be able to decrease economic capital, that is, decrease the amount of capital the firm needs to hold to cover its risks if the correlations between the risks can be estimated.
How did enterprise risk management (ERM) extend this concept and what does it allow a company to hold less of?
a. Enterprise Rsk Management (ERM) adopted this concept and extended it to consider the portfolio view of all risks facing a company, which allows a company to hold less capital if it considers those risks in a portfolio.
What flood disasters are a good indication that historical data may no longer be a good predictor of future events/losses?
a. Houston has had three so-called "500 year floods" in the past 30 years. This is an example that shows that historical data may no longer be a good predictor of future events/losses.
Until the 1970s, what was the only type of risks that companies managed?
companies only managed hazard risks
What are stress tests often based on?
historical events or various other scenarios
What kind of distribution does credit loss typically follow?
lognormal distribution
What are examples of four categories of risk the company might identify?
market (e.g. equity price fall, fixed interest, yield move) credit insurance operational
What is the market value of an asset?
market value" is the actual value you could get if you tried to sell the asset.
In other words, what does economic capital provide management with and what does this allow the comparison and discussion of?
the limitation of assuming a normal distribution in the world of financial
What limitation of VaR does stress testing overcome?
the limitation of assuming a normal distribution in the world of financial markets
Why do companies pay attention to rating agencies?
the limitation of assuming a normal distribution in the world of financial markets
When you consider risks in a portfolio instead of individually in silos, what do you need to understand?
you need to understand the correlation (interrelation) between risks.
