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Risk Measurement and Management in a Crisis-Prone World

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  • Wong, Woon K

    ()
    (Cardiff Business School)

  • Copeland, Laurence

    ()
    (Cardiff Business School)

Abstract

The current subprime crisis has prompted us to look again into the nature of risk at the tail of the distribution. In particular, we investigate the risk contribution of an asset, which has infrequent but huge losses, to a portfolio using two risk measures, namely Value-at-Risk (VaR) and Expected Shortfall (ES). While ES is found to measure the tail risk contribution effectively, VaR is consistent with intuition only if the underlying return distribution is well behaved. To facilitate the use of ES, we present a power function formula that can calculate accurately the critical values of the ES test statistic. This in turn enables us to derive a size-based multiplication factor for risk capital requirement.

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Bibliographic Info

Paper provided by Cardiff University, Cardiff Business School, Economics Section in its series Cardiff Economics Working Papers with number E2008/14.

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Length: 27 pages
Date of creation: Jul 2008
Date of revision:
Handle: RePEc:cdf:wpaper:2008/14

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Keywords: Value-at-Risk; expected shortfall; tail risk contribution; saddle point technique; risk capital;

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  1. Jeremy Berkowitz & James O'Brien, 2002. "How Accurate Are Value-at-Risk Models at Commercial Banks?," Journal of Finance, American Finance Association, vol. 57(3), pages 1093-1111, 06.
  2. Philippe Jorion, 2000. "Risk management lessons from Long‐Term Capital Management," European Financial Management, European Financial Management Association, vol. 6(3), pages 277-300.
  3. GIOT, Pierre & LAURENT, Sébastien, . "Value-at-Risk for long and short trading positions," CORE Discussion Papers RP -1707, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  4. Christoffersen, Peter F, 1998. "Evaluating Interval Forecasts," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(4), pages 841-62, November.
  5. Suleyman Basak & Alex Shapiro, . "Value-at-Risk Based Risk Management: Optimal Policies and Asset Prices," Rodney L. White Center for Financial Research Working Papers 06-99, Wharton School Rodney L. White Center for Financial Research.
  6. Pierre Giot and S»bastien Laurent, 2001. "Value-At-Risk For Long And Short Trading Positions," Computing in Economics and Finance 2001 94, Society for Computational Economics.
  7. Kerkhof, F.L.J. & Melenberg, B., 2002. "Backtesting for Risk-Based Regulatory Capital," Discussion Paper 2002-110, Tilburg University, Center for Economic Research.
  8. Dirk Tasche, 2002. "Expected Shortfall and Beyond," Papers cond-mat/0203558, arXiv.org, revised Oct 2002.
  9. Vikas Agarwal, 2004. "Risks and Portfolio Decisions Involving Hedge Funds," Review of Financial Studies, Society for Financial Studies, vol. 17(1), pages 63-98.
  10. Paul H. Kupiec, 1995. "Techniques for verifying the accuracy of risk measurement models," Finance and Economics Discussion Series 95-24, Board of Governors of the Federal Reserve System (U.S.).
  11. Wong, Woon K., 2008. "Backtesting trading risk of commercial banks using expected shortfall," Journal of Banking & Finance, Elsevier, vol. 32(7), pages 1404-1415, July.
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