Risk measure

In financial mathematics, a risk measure is used to determine the amount of an asset or set of assets (traditionally currency) to be kept in reserve. The purpose of this reserve is to make the risks taken by financial institutions, such as banks and insurance companies, acceptable to the regulator. In recent years attention has turned to convex and coherent risk measurement.

Mathematically

A risk measure is defined as a mapping from a set of random variables to the real numbers. This set of random variables represents portfolio returns. The common notation for a risk measure associated with a random variable $X$ is $\rho (X)$ . A risk measure $\rho :{\mathcal {L}}\to \mathbb {R} \cup \{+\infty \}$ should have certain properties:^[1]

Normalized: $\rho (0)=0$

Translative: $\mathrm {If} \;a\in \mathbb {R} \;\mathrm {and} \;Z\in {\mathcal {L}},\;\mathrm {then} \;\rho (Z+a)=\rho (Z)-a$

Monotone: $\mathrm {If} \;Z_{1},Z_{2}\in {\mathcal {L}}\;\mathrm {and} \;Z_{1}\leq Z_{2},\;\mathrm {then} \;\rho (Z_{2})\leq \rho (Z_{1})$

Set-valued

In a situation with $\mathbb {R} ^{d}$ -valued portfolios such that risk can be measured in $m\leq d$ of the assets, then a set of portfolios is the proper way to depict risk. Set-valued risk measures are useful for markets with transaction costs.^[2]

Mathematically

A set-valued risk measure is a function $R:L_{d}^{p}\rightarrow \mathbb {F} _{M}$ , where $L_{d}^{p}$ is a $d$ -dimensional Lp space, $\mathbb {F} _{M}=\{D\subseteq M:D=cl(D+K_{M})\}$ , and $K_{M}=K\cap M$ where $K$ is a constant solvency cone and $M$ is the set of portfolios of the $m$ reference assets. $R$ must have the following properties:^[3]

Normalized: $K_{M}\subseteq R(0){\text{ and }}R(0)\cap -\operatorname {int} K_{M}=\emptyset$

Translative in M: $\forall X\in L_{d}^{p},\forall u\in M:R(X+u1)=R(X)-u$

Monotone: $\forall X_{2}-X_{1}\in L_{d}^{p}(K)\Rightarrow R(X_{2})\supseteq R(X_{1})$

Examples

Variance

Variance (or standard deviation) is not a risk measure in the above sense. This can be seen since it has neither the translation property nor monotonicity. That is, $Var(X+a)=Var(X)\neq Var(X)-a$ for all $a\in \mathbb {R}$ , and a simple counterexample for monotonicity can be found. The standard deviation is a deviation risk measure. To avoid any confusion, note that deviation risk measures, such as variance and standard deviation are sometimes called risk measures in different fields.

Relation to acceptance set

There is a one-to-one correspondence between an acceptance set and a corresponding risk measure. As defined below it can be shown that $R_{A_{R}}(X)=R(X)$ and $A_{R_{A}}=A$ .^[5]

Risk measure to acceptance set

If $\rho$ is a (scalar) risk measure then $A_{\rho }=\{X\in L^{p}:\rho (X)\leq 0\}$ is an acceptance set.
If $R$ is a set-valued risk measure then $A_{R}=\{X\in L_{d}^{p}:0\in R(X)\}$ is an acceptance set.

Acceptance set to risk measure

If $A$ is an acceptance set (in 1-d) then $\rho _{A}(X)=\inf\{u\in \mathbb {R} :X+u1\in A\}$ defines a (scalar) risk measure.
If $A$ is an acceptance set then $R_{A}(X)=\{u\in M:X+u1\in A\}$ is a set-valued risk measure.

Relation with deviation risk measure

There is a one-to-one relationship between a deviation risk measure D and an expectation-bounded risk measure $\rho$ where for any $X\in {\mathcal {L}}^{2}$

$D(X)=\rho (X-\mathbb {E} [X])$
$\rho (X)=D(X)-\mathbb {E} [X]$ .

$\rho$ is called expectation bounded if it satisfies $\rho (X)>\mathbb {E} [-X]$ for any nonconstant X and $\rho (X)=\mathbb {E} [-X]$ for any constant X.^[6]

References

^ Artzner, Philippe; Delbaen, Freddy; Eber, Jean-Marc; Heath, David (1999). "Coherent Measures of Risk" (PDF). Mathematical Finance. 9 (3): 203–228. doi:10.1111/1467-9965.00068. S2CID 6770585. Retrieved February 3, 2011.
^ Jouini, Elyes; Meddeb, Moncef; Touzi, Nizar (2004). "Vector–valued coherent risk measures". Finance and Stochastics. 8 (4): 531–552. CiteSeerX 10.1.1.721.6338. doi:10.1007/s00780-004-0127-6. S2CID 18237100.
^ Hamel, A. H.; Heyde, F. (2010). "Duality for Set-Valued Measures of Risk". SIAM Journal on Financial Mathematics. 1 (1): 66–95. CiteSeerX 10.1.1.514.8477. doi:10.1137/080743494.
^ Jokhadze, Valeriane; Schmidt, Wolfgang M. (March 2020). "Measuring model risk in financial risk management and pricing". International Journal of Theoretical and Applied Finance. 23 (2) 2050012. doi:10.1142/s0219024920500120. SSRN 3113139.
^ Andreas H. Hamel; Frank Heyde; Birgit Rudloff (2011). "Set-valued risk measures for conical market models". Mathematics and Financial Economics. 5 (1): 1–28. arXiv:1011.5986. doi:10.1007/s11579-011-0047-0. S2CID 154784949.
^ Rockafellar, Tyrrell; Uryasev, Stanislav; Zabarankin, Michael (22 January 2003). "Deviation Measures in Risk Analysis and Optimization". SSRN 365640.

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Langbahn Team – Weltmeisterschaft

Risk measure

Mathematically

Set-valued

Mathematically

Examples

Variance

Relation to acceptance set

Risk measure to acceptance set

Acceptance set to risk measure

Relation with deviation risk measure

See also

References

Further reading