Risk Types & Measurement

Types of Risk

On the basis of Source Technological Risk, Political Risk On the basis of Managerial Perspective Avoidable Risk, Transferable Risk, Manageable Risk On the basis of Functionality Credit Risk, Market Risk

Types of Risk
-

Credit Risk or Counter-Party Risk Market Risk or Price Risk Short Squeeze is a rapid increase in the price of a stock that occurs when there is a lack of supply and an excess of demand for the stock. It results when short sellers cover their positions on a stock. Long Squeeze is a situation in which investors who hold long positions feel the need to sell into a falling market to cut their losses. This pressure to sell usually leads to a further decline in market prices.

Types of Risk

Liquidity Risk Legal & Regulatory Risk Operating Risk Internal Risk Factors People (Employee Fraud, Employee Error, Lack of Skills, Loss of Key Employee), Processes (Transaction Error, Reporting Error, Valuation Error, Accounting Error), Systems (Inadequate Capacity, Breach of Security, Frequent Systems Breakdown, Systems Incompatibility) External Risk Factors Intangible (Legal & Regulatory, Political, Taxation), Tangible (Natural Calamities, Terrorism, Physical Security)

Risks in Derivatives Markets

Credit Risk MTM & TGF to avoid it in India Market Risk Operational Risk includes Settlement Risk, Legal Risk & Control Risk Strategic Risk Systemic Risk

Risk Measurement

Range Variance measures the variability (volatility) from an average. Volatility is a measure of risk which helps to determine the risk an investor might take on purchasing a specific security Standard Deviation is a statistical measurement for historical volatility. For example, a volatile stock will have a high standard deviation while the deviation of a stable blue chip stock will be lower. A large dispersion tells us how much the return on the fund is deviating from the expected normal returns

Value At Risk

VAR states with X% certainty that not more than Y amount of rupees will be lost in next N days. For example, existing portfolio value today is Rs.3,00,000 and if the portfolio VAR is 4.3% at 99% confidence interval over one day horizon, then it means that the maximum loss in the value of the portfolio on next day with 99% certainty will not be more than Rs.17,200 (ie) 4.3% of Rs.3,00,000 In other words, there are only 1% chances that the loss in value of portfolio on next day will be more than Rs.17,200

Methods of Computing VAR

Historical Method Parametric or Analytic Method The Simulation or Monte Carlo Method

Historical Method

This is the most simple method wherein the historical returns are arranged in descending order (ie) largest to smallest. Suppose we have 100 observations of the returns of our portfolio, then we would simply arrange the returns from largest to smallest. The VAR for the 95th percentile (ie) for 95% confidence interval would then be the 6th largest loss. The advantage of this method is that it requires no assumption to be made about the nature or shape of the distribution of returns. The disadvantage is that we are thus assuming that the shape of future returns will be the same as those of the past.

Parametric or Analytic Method

This method requires an assumption to be made about the statistical distribution (normal, log-normal, etc) from which the data is drawn. We can think of parametric approaches as fitting curves through the data and then reading off the VAR from the fitted curve. The attraction of this method is that relatively less information is needed to compute it. The weakness is that the distribution chosen may not accurately reflect all possible states of the market and may under or over estimate the risk.

The Simulation or Monte Carlo Method

This method has become increasingly popular in recent years due to the dramatic increase in the availability and power of desktop computers. As the name implies, simulation VAR generates many thousand simulated returns drawn either from a parametric assumption about the shape of distribution or preferably by re-sampling the historical data by re-arranging them according to their statistical significance and then taking the desired percentile as in the historical calculation method. So, basically, it is the combination of the Historical Method and the Parametric or Analytical Method which brings it more towards the accuracy level.

Limitations of VAR

VAR is fast replacing the traditional method of computing risk (ie) Volatility and Standard Deviation as it is a better measure compared to both of them. VAR should only be used as either supplementary or complementary measure of risk and should not fully substitute the traditional method of measuring risk because of its below limitations :It does not describe the distribution of losses. It cannot be used on stand-alone basis and so has to be accompanied by stress-testing. It is subject to some sampling variation as a different sampling period or a period of different length would automatically produce different VAR numbers. Liquidity Risk cannot be adequately captured by VAR.