Set out how sensitivity and scenario risk measures are applied
The idea
Sensitivity measures are used to set and monitor exposures: a bond desk limits portfolio duration, an equity manager limits beta, and an options desk limits delta, gamma and vega. Scenario measures address particular events. Historical scenarios revalue today's portfolio under the market moves of a past episode, such as a rate shock or equity crash. Hypothetical scenarios model events that have not happened, or combine shocks deliberately, for example with correlations that rise in a crisis. Reverse stress tests start from an unacceptable loss and work back to the conditions that would cause it. The trap is applying a historical scenario to the portfolio held at the time rather than to today's positions.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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- Explain how value at risk (VaR) is applied to gauge the risk of a portfolio
- Contrast three ways to estimate VaR: Monte Carlo simulation, historical simulation, and the parametric (variance–covariance) method
- Estimate VaR by Monte Carlo simulation, by historical simulation, and by the parametric method, and explain what each result means
- Set out the strengths and weaknesses of VaR
- Set out the ways VaR has been extended
- Explain sensitivity and scenario risk measures and weigh them against VaR
- Show how exposure measures for equities, fixed income, and options can help gauge and control market risk and volatility risk
- Set out the strengths and weaknesses of sensitivity and scenario risk measures
- Explain the limits used to control market risk, among them stop-loss limits, scenario limits, position limits, and risk budgeting
- Explain how risk measures can guide decisions on allocating capital
- Set out the risk measures relied on by insurers, pension funds, asset managers, and banks