Portfolio Management II
Reading 55. An Introduction to Risk Management
Learning Outcome Statements
g. describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods.
CFA Curriculum, 2020, Volume 4
Subject 4. Measuring and Modifying Risks
To understand how to measure risk, we need to first understand what drives risk. Risk drivers are the fundamental global and domestic macroeconomic and industry factors that create risk.
- All risks come from uncertainties.
- Financial risks come from fundamental factors in macro-economies and industries.
- There are systematic risks and unsystematic (diversifiable) risks.
Risk management can control some risks but not all.
Common measures of risk:
- Standard deviation: measures dispersion in a probability distribution. This has significant limitations.
- Beta: measures the sensitivity of a security's returns to the returns on the market portfolio.
- Measures of derivatives risk: delta, gamma, vega and rho.
- Duration measures the interest rate sensitivity of a fixed income security.
- Value at Risk: measures the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval. If the VaR on an asset is $100 million at a one-week, 95% confidence level, there is only a 5% chance that the value of the asset will drop more than $ 100 million over any given week.
- CVaR: scenario analysis and stress testing, can be used to complement VaR.
It is difficult to measure rare events such as operational risk and default risk.
Methods of Risk Modification
There are four broad categories of risk modification.
Risk prevention and avoidance. Completely avoiding risk sounds simple, but it may be difficult or sometimes impossible. Furthermore, does it even make sense to do so? Almost every risk has an upside. There is always a trade-off between risk and return.
Risk acceptance. Risk can be mitigated internally through self-insurance or diversification. This is to bear the risk but do so in the most efficient manner possible.
Risk transfer. This is to pass on a risk to another party, often in the form of an insurance policy. An insurer attempts to sell policies with risks that have low correlations and can be diversified away.
Risk shifting. This refers to actions that change the distribution of risk outcomes. The principal device is a derivative which can be used to shift risk across the probability distribution and from one party to another. There are two categories of derivatives: forward commitments and contingent claims.
The primary determinant of which method is best for modifying risk is weighing the benefits against the costs, with consideration for the overall final risk profile and adherence to risk governance objectives.