Statistical Risk Analysis

Abstract

Risk is an inherent quantity in financial markets and is of utmost importance to investors and policymakers. Many methods have been proposed to measure, monitor, and control the risks. There are different kinds of risks. Market risk is the risk to the portfolio from a decline in the market price of instruments in the portfolio. Liquidity risk is the risk that the holder of an instrument will find that a position is illiquid and will incur extra costs in unwinding the position resulting in a less favorable price for the instrument. Credit risk involves the risk that promised payments on a loan or bond will not be made, or that a convertible instrument will not be converted in a timely manner or at all. Other types of risk include interest rate and foreign exchange risks that can also randomly change over time and are of relevance to an investment portfolio. Tools have evolved to measure all these different components of risk. Processes must be put into place to monitor the changing risks in a portfolio and to control the magnitude of risks. For an extensive treatment of these topics, see Litterman et al. (1998). In this chapter we shall discuss only market risks, see Dowd (2007).