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Topic 2 Risk Measures (Week 1)
Topic 2 Risk Measures (Week 1)
▶ Risk Measures
▶ Value at Risk
▶ Variance
▶ Expected Shortfall
▶ Coherent Risk Measures
▶ Convex Risk Measures
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Applications of Risk Measures
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Examples of Risk Measures
▶ Value at Risk
▶ Variance
▶ Moment based risk measures
▶ Expected shortfall
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Value at Risk
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Value at Risk: Normal distribution
▶ For normal distribution of FL (l) with mean µ and variance σ 2
we have
VaRα (L) = µ + σΦ−1 (α) ,
where Φ is the standard normal distribution function and
Φ−1 (α) is the α quantile of Φ.
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Value at Risk: Some Potential Issues
▶ VaR ignores model risk - you may be using the wrong loss model
(and parameters are estimated from data).
▶ VaR ignores liquidity which impacts on time taken to trade
securities.
▶ Horizon for VaR need to reflect the time period the portfolio is
expected to be held
▶ VaR is not sub-additive - the VaR of a portfolio could be greater
than the sum of the VaR’s of the individual risks (to be discussed
in the next lecture).
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Variance
For a risk L with mean µ and finite second moment,
var (L) = E (L − µ)2 .
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Expected Shortfall
1
Note that different authors use different names with subtle differences.
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Exercise
Show that the expected shortfall at level α is always greater than or
equal to the value at risk at the same level α:
ESα ≥ VaRα
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Expected Shortfall
▶ For a continuous integrable loss L with continuous df FL ,
E (L; L ≥ qα (L))
ESα = = E (L|L ≥ VaRα ) , α ∈ (0, 1).
1−α
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If FL is normal with mean µ and variance σ 2 then
ϕ Φ−1 (α)
ESα = µ + σ
1−α
where ϕ is the density of the standard normal distribution.
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Desired Properties of a Risk Measure
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Coherence: Monotonicity
Axiom (monotonicity). For two risks L1 and L2 such that L1 ≤ L2
almost surely, we have ρ(L1 ) ≤ ρ(L2 ).
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Coherence: Translation Invariance
Axiom (translation invariance). For all risks L and every l ∈ R we
have ρ(L + l) = ρ(L) + l.
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Coherence: Subadditivity
Axiom (subadditivity). For all risks L1 and L2 we have
ρ(L1 + L2 ) ≤ ρ(L1 ) + ρ(L2 ).
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Coherence: Positive Homogeneity
Axiom (positive homogeneity). For all risks L and every λ > 0 we
have ρ(λL) = λρ(L).
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Non-Subadditivity of VaR
Example (non-subadditivity of VaR). Consider a portfolio of two
zero-coupon bonds with a maturity of one year that default
independently. Assume:
▶ Each bond has a default probability p = 0.9%;
▶ The current price of the bonds and the face value of the bonds is
equal to 100;
▶ The bonds pay an interest rate of 5%.
Denote by Li the loss incurred by holding one unit of bond i, and
write L = L1 + L2 .
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Coherence of ES
Example 2.26 (coherence of expected shortfall). Translation
invariance, monotonicity and positive homogeneity are immediate
from the corresponding properties of the quantile.
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Convex Risk Measure
Axiom (Convexity). For all risks L1 and L2 and all λ ∈ [0, 1], we have
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Exercise
Show that a coherent risk measure is a convex risk measure.
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