Question

Explain how total portfolio risk can be decomposed in various risk exposures and indicate why risk decomposition can be a complex exercise.

Answer 1

Decomposition of Risk by Positions • several systems vendors attempt to decompose risk (either variance or standard deviation) by the position. – typically this can beoften seemed to be intuitive for volt-ampere calculations at banks (e.g. what quantity risk comes from every loan) as a result of the choice is to not build the loan , and that we area unit measurement risk of loss in dollar amounts. – For quality management, the quantity of capital (AUM) to be place in danger is fastened (i.e. institutional purchasers don’t pay quality managers to cover cash below their mattress). – essentially, we have a tendency to area unit deciding whether or not we have a tendency to do or don’t need to enforce the need that quality weights total to 100% – intrinsically, any algebraical decomposition of risk by position needs (either expressly or implicitly) the definition of a “contra-asset” that defines wherever the return of closing out a foothold are going to be deployed.
How much risk we have a tendency to allot to a given issue is heavily influenced by the estimation method of the model. – The lustiness of applied math estimates will typically be improved by staged estimations, however at the price of a lot of advanced interpretation • Risk service vendors report the decomposition of risk otherwise – several of the news procedures follow AN algebraical instead of economic reasoning – abundant of the paradox relates to however the variance terms area unit allotted to the concerned factors • once coping with “incremental risk contributions by position” we'll be either implicitly or expressly coping with the existence of the contra-asset – just some of the attainable definitions of the contra-asset have straightforward algebraical structure.