Risk measure

Not to be confused with deviation risk measures, e.g. standard deviation .

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 towards 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: $K_M \subseteq R(0) \; \mathrm{and} \; R(0) \cap -\mathrm{int}K_M = \emptyset$

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. 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.

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 $A_{{R_{A}}}=A$ .^[4]

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.^[5]

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. Retrieved February 3, 2011.
↑ Jouini, Elyes; Meddeb, Moncef; Touzi, Nizar (2004). "Vector–valued coherent risk measures". Finance and Stochastics. 8 (4): 531–552. doi:10.1007/s00780-004-0127-6.
↑ Hamel, A. H.; Heyde, F. (2010). "Duality for Set-Valued Measures of Risk" (pdf). SIAM Journal on Financial Mathematics. 1 (1): 66–95. doi:10.1137/080743494. Retrieved August 17, 2012.
↑ Andreas H. Hamel; Frank Heyde; Birgit Rudloff (2011). "Set-valued risk measures for conical market models" (pdf). Mathematics and Financial Economics. 5 (1): 1–28. doi:10.1007/s11579-011-0047-0. Retrieved April 20, 2012.
↑ Rockafellar, Tyrrell; Uryasev, Stanislav; Zabarankin, Michael (2002). "Deviation Measures in Risk Analysis and Optimization" (pdf). Retrieved October 13, 2011.

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