Risk Management: Facing New Challenges

Article excerpt

The current financial crisis has demonstrated the shortcomings of standard risk evaluation methods. This was especially evident in most risky investment strategies, such as volatility trading and shorting naked options. The changing markets require the development of alternative risk indicators.

The market crash of 1 987 revealed the failure of risk management systems. This stimulated the search for new approaches, which led to the development of the Value at Risk (VaR) concept. In the 1990s, this risk measure became standard, and in 1999 it received official and international status in the Basel agreements.

In the course of time, VaR became a compulsory characteristic in the reports of most financial institutions. Step by step, market professionals came to believe that this indicator adequately described the risk of any investment portfolio regardless of structure or complexity. However, the financial crisis of 2008 revealed inconsistencies between forecasts based on VaR and actual losses incurred by market participants.

Such divergence between forecasts and reality were due to fundamental changes in the financial markets over the last 20 years. A vast quantity of complex financial products has been created recently, and sophisticated investors have' shifted priorities from plain assets (stocks and bonds) to derivatives (futures, options, convertible bonds, credit swaps, etc.). In spite of these developments, risk evaluation mechanisms remained static. Today, a new financial era is evident, one that requires not only adaptation of risk evaluation methods but also the invention of fundamentally new approaches.

This implies a shift away from a onesided system of risk estimation (such VaR) to the development of a whole set of evaluating algorithms based on different principles. Instead of fixing a new common standard, a multitude of alternative risk indicators will be necessary. Their application area should also be extended from assessment of existing investments to active utilization at the portfolio composition and structuring stage. Alternative indicators should be unique and independent (not correlated). Each should supplement the information contained in the other indicators, not duplicate it.

This article will examine four indicators, traditional VaR and three alternatives. The next part of this series will examine their intenelationship in assessing the risk of a complex option portfolio.


Two of the four indicators are calculated analytically using mathematical formulas (index delta and asymmetry coefficient), while the two others are estimated numerically via Monte Carlo simulation (loss probability and VaR).

Asymmetry coefficient. This indica- tor expresses the skewness of the payoff function of the option portfolio. Most strategies selling naked options are based on the concept of market neutrality. If the portfolio is really market-neutral, its payoff function should be sufficiently symmetrica] relative to the current value of a certain index. Such symmetry implies that the value of the portfolio will change roughly equally regardless of market direction. …