Unit
- Risk vs uncertainty: Risk refers to situations where probabilities of outcomes are known or can be estimated, while uncertainty involves unknown probabilities. Financial risk management focuses on measurable risk, but unexpected events can shift outcomes into uncertainty.
- Types of financial risk: Market risk arises from price movements in equities, interest rates, currencies, and commodities. Credit risk involves counterparty default. Operational risk stems from internal failures. Liquidity risk concerns the ability to trade without price distortion.
- Loss distribution: The probability distribution of portfolio losses over a given horizon is central to risk measurement. It includes expected loss (mean) and unexpected loss (deviation from mean). Tail losses beyond a threshold are the focus of Expected Shortfall.
- Risk metrics: Common metrics include standard deviation (volatility), semi-deviation (downside risk), Value at Risk (quantile), and Expected Shortfall (tail average). Each captures different aspects of the loss distribution.
- Time horizon: Risk measures depend on the holding period. Liquidity considerations, trading frequency, and regulatory standards (e.g., 10-day for market risk) influence the choice. Longer horizons increase potential losses.
- Confidence level: Typical levels are 95%, 97.5%, and 99%. Higher confidence captures more extreme losses but requires more data for estimation. ES at 97.5% is the Basel standard.
- Model risk: Assumptions about return distributions (normality, independence) introduce model risk. Real-world returns exhibit fat tails and skewness, making non-parametric methods attractive.
- Regulatory context: The Basel Committee mandates ES for market risk, and the SEC requires it for certain filings. Understanding the regulatory landscape is essential for compliance.
Risk Assessment
MEDIUM RISK
Market risk is typically classified as medium risk because while price movements are frequent, they are usually within historical bounds. However, tail events can escalate risk to high levels, which Expected Shortfall aims to capture.
Quick Revision
- Risk is measurable with probabilities; uncertainty is not. Both matter in financial risk management.
- The four primary risk types are market, credit, operational, and liquidity.
- Loss distributions summarize expected and unexpected losses, with tails critical for extreme events.
- Different risk metrics capture different aspects; ES is a coherent tail-risk measure.