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What is risk and how to measure risk?

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Analysis:

The simplest definition of risk is “functioning” uncertainty,” it works because it affects one or more goals. Risk does not exist in a vacuum, so we need to define what is “at risk”, that is, what objectives would be affected if the risk occurred.

Therefore, a more complete definition of risk is "uncertainty that can affect one or more objectives." This definition allows us to recognize that some uncertainties are not relevant to the objectives and should be excluded from the risk management process.

Risk measurement

After identifying the market risk factors that have a significant impact on the company, it is necessary to measure various risk factors, that is, to conduct a quantitative analysis of risks.

Currently commonly used market risk measurement indicators can be roughly divided into two types, namely relative measurement indicators and absolute measurement indicators of risk. Relative metrics mainly measure the relationship between changes in market factors and changes in financial asset returns.

2.2.1 Relative indicators

Duration, the sensitivity of bond prices to changes in interest rates, is used to measure interest rate risk.

Convexity, the sensitivity of duration itself to changes in interest rates, is usually used in conjunction with duration to improve the accuracy of interest rate risk measurement.

DV01, the degree of change in bond prices caused by a 0.01 percentage point change in the interest rate level, is used to measure interest rate risk.

Beta coefficient, Beta coefficient is an indicator used to measure the degree to which individual stocks are affected by the entire economic environment, including stock market price changes. Beta coefficient is used to measure stock price risk.

The following indicators are only used to measure risk in the derivatives market (including commodity futures, financial futures)

Delta, the price of derivatives (including futures, options, etc.) relative to its The sensitivity of underlying asset (Underlying asset) price changes, Delta is used to measure commodity price risk or stock price risk.

Gamma, the sensitivity of Delta itself relative to the price changes of its underlying assets, is usually used in conjunction with Delta to improve the accuracy of commodity price risk or stock price risk measurement.

Vega, the sensitivity of the price of a derivative product to changes in its volatility (Volatility), Vega is used to measure commodity price risk or stock price risk.

Theta, the sensitivity of a derivative's price to changes in the length of time until its expiration date.

Rho, the sensitivity of the price of derivative products to changes in interest rate levels, Rho is used to measure interest rate risk.

Usually, we use relative indicators to conduct sensitivity analysis on relevant market risks and estimate profits and losses under two scenarios: mild market fluctuations and severe market fluctuations. Only one important risk factor is considered in each calculation, such as interest rates, exchange rates, securities and commodity prices, etc., while assuming that other factors remain unchanged. Based on this, the risk management department can detect market risks across the company and adjust the asset structure as needed.

2.2.2 Absolute indicators

Variance/standard deviation. Variance or standard deviation is widely accepted by academics and practitioners as a measure of financial asset risk. In Harry Markowitz's paper "Portfolio Selection" published in 1952, Markowitz assumed that investment risk can be regarded as the uncertainty of investment returns. This uncertainty can be measured by the variance (Variance) or standard deviation (Standard deviation) in statistics. measure. For example, if the value of a certain financial asset portfolio is $1 million and the standard deviation is 5%, the risk of the portfolio may be $50,000. Because variance has good statistical properties, it is widely used to measure the risk of financial asset portfolios.

Downside-Risk. The variance/standard deviation method measures both the positive and negative effects of risk, and people generally believe that risk has only negative effects. Therefore, measuring risk using the variance/standard deviation method cannot reflect people's true psychological feelings.

In response to this flaw of the variance/standard deviation method, the Downside-Risk method does not consider the positive impact of risk and only depicts the return distribution relative to a certain target return level (usually the overall average level or zero return level). The theoretical basis of this type of method is: for various return rate distributions, when investors consider and manage risks, they focus on the left side of the return rate distribution. Based on this premise, many methods are produced to describe the relative return level relative to a certain target. Risk indicators of return distribution characteristics, among which Harlow’s LPM method is the most representative and has formed a relatively mature theoretical system. Similar to variance/standard deviation, the Downside-Risk method is mainly used to measure the risk of financial asset portfolios.

Value at Risk (VaR). VaR represents current best practice in market risk measurement. It originated in the 1980s, but as a tool for market risk measurement and management, it was proposed by J.P Man Investment Bank in the RiskMetrics system in 1994. The definition of VaR is, at a certain level of confidence, the maximum loss value that may occur in the entire asset portfolio in a certain period in the future due to market fluctuations. Mathematically, VaR is expressed as the α quantile of the profit and loss distribution of an investment instrument or portfolio, which is expressed as follows: Pr (Δp <= -VaR) = α, where Δp represents the internal confidence level of the investment portfolio during the holding period Δt ( 1-α) loss of market value. For example, if a company's 10-day VaR is $1 million with a 95% confidence level, that means the company's risk loss will exceed $1 million in the next 10 days. The probability is only 5%. Because the VaR method can simply and clearly express the market risk of financial asset positions, and is based on relatively strict statistical theory, it has been widely recognized by international financial theory and industry. The International Banking Basel Committee (Basle Committee) also uses the market risk estimated by the VaR model to determine the capital adequacy ratio of banks and other financial institutions.

Combining the above methods to conduct quantitative analysis of risks can enable the company to clarify the size of the risks it faces and lay the foundation for further risk management activities.