Explain sensitivity and scenario risk measures and weigh them against VaR
The idea
Sensitivity measures show how value changes for a small move in one risk factor: beta for equity markets, duration and convexity for interest rates, delta, gamma and vega for options. They are precise about direction and size of exposure but carry no probability and cannot easily be added across asset types. Scenario measures ask what a portfolio would lose under a specified set of moves in many factors at once, drawn from history or built hypothetically. VaR combines exposures with a probability distribution but says nothing about particular events. The trap is expecting a sensitivity or a scenario to say how likely a loss is; only a probabilistic measure such as VaR does that.
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- Explain how value at risk (VaR) is applied to gauge the risk of a portfolio
- Contrast three ways to estimate VaR: Monte Carlo simulation, historical simulation, and the parametric (variance–covariance) method
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- Set out the ways VaR has been extended
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- Set out how sensitivity and scenario risk measures are applied
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- Explain how risk measures can guide decisions on allocating capital
- Set out the risk measures relied on by insurers, pension funds, asset managers, and banks