Financial Risk Management

On Volatility versus Risk I commented on Risk and Volatility, without however mentioning practical activities related to the direct use of metrics for risk. 

 

Market risk, which is the possibility of financial loss due to the typical ups and downs of the market, should, as the intuition suggests, reflect the degree of oscillation that the asset provides.

The simplest metric, known and used for this purpose is the standard deviation. The standard deviation has inaccuracies in quantifying the risk, because strictly financial returns do not follow a normal distribution, which is the necessary premise to calculate the standard deviation. The metric of the standard deviation necessarily produce a bias, always deviated from the true value.

The biggest problem with the standard deviation, however, is not the premise that it performs when considering the normal data. The standard deviation by itself does not present the risk management of an efficient way, because it still lacks the statistical scenario was considered.

Value-at-Risk

The methodology Value-at-Risk (VaR) fills this gap. It was developed in order to produce management reports more objective and intuitive. His metric is well established in statistical terms and reflects exactly what one would expect from a market risk measure. The VaR results in a net asset value, or a possibility of financial loss. This possibility of financial loss is tied to a time interval and statistical significance. So we say: The portfolio has the possibility of losing $X on Y days (or hours) with a statistical significance of Z%. 

 

Financial processes, however, do not follow a behavior said homoscedastic or constant over time but heteroscedastic. The volatility can undergo dramatic changes as in times of crisis. These phenomena can cause a sharp drop in equity of a particular institution leading to bankruptcy in many cases. 

Stress 

An analysis complementary to VaR, called Stress analysis is used to simulate situations of panic and financial crises. These simulations analyze the tails of the distributions of returns and evaluate the portfolio in more extreme scenarios. It is possible to simulate historical crises, specific situations and scenarios to highly pessimistic and uncorrelated. 

It is necessary to understand the main feature of the market is the strong stochastic process which asset prices are submitted. Unexpected situations are possible and even expected, and it is impossible to predict turbulence and crisis situations with sufficient precision. The Financial Risk Management, however, has enough tools to evaluate and quantify the risks and fluctuations to which the portfolio is submitted.

Volatility versus. Risk

The modern portfolio management necessarily lead to financial risk metrics. The concept of risk and volatility, however, are not fully understood, including the financial surrounding.

Risk is a possibility of financial loss. In the financial market through a few different types of risk such as operational risks (related to typical human failures) or the credit risk (mainly in debt securities), but the main risk is considered in the financial market risk. This risk is also known as volatility.

Volatility represents the level of fluctuation in the price of paper. If priced paper financial bounce, either up or down, an observed behavior in crisis, their volatility is so high.

Standard Deviation

This metric is obtained through statistical techniques, but can be understood intuitively. The standard deviation, which is a measure for dispersion is often used by the market to quantify market risk. This measure takes into account an assumption that the returns of the asset price analysis assumes a normal distribution.

Risk is Good or Bad?

Risk, by its very definition is unwanted because it is the representation of their financial loss. However, the volatility is not always undesirable since it is on account of it that makes it possible to profit by the financial investment or speculation.

It seems somewhat paradoxical to imagine two very interconnected which is an unwanted and the other is desirable. But if we imagine free market volatility, we cannot think of speculative gains.

Volatility is Good or Bad?

Volatility is a natural feature of financial markets and reflects the diverse interactions of market participants. For some volatility is undesirable, as on agribusiness who, while waiting to harvest and sale, assumes currency exposures, as the price of their commodities, interest rates, etc..
For qualified institutions to deal with the volatility as banks, investors and speculators volatility is desired, and often through the mechanisms of high leverage so they can generate more return possibilities.

Controlling the Risk!

Financial risk can be measured and mechanisms as well as the diversification of roles and help hedge in its control. The risk monitoring and simulation scenarios are indispensable tools for anyone who has exposed to financial market operations.