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# Extreme Risk Analysis

## MSCI Barra Research

Lisa R. Goldberg
Michael Y. Hayes
Jose Menchero
Indrajit Mitra

Summary
Timely: draft version published in February 2009, Lehman collapsed
on Sep 15, 2008.
Volatility is not an ideal risk measure, VaR has shortcomings, advocate
for the usage of expected shortfall (which they call shortfall)
Shows how to use some intuitive volatility decompositions to analyze
and manage risk
Example-based, math in the Appendix
Quantitative Risk Management
Risk measurement: quantifying the overall risk of a portfolio
Risk analysis: gaining insight into the sources of risk

Crisis in 2008-2009 provides motivation to think differently about risk,
and shows the importance of considering risk measures that perform
well in all types of climates.
Risk Measurement
Risk measures - Volatility
Volatility is the classic risk measure, since Markowitz (1952). It has
several positive features:
Favors diversification over concentration
Possible analytic solutions
Easy to measure and possible to forecast
Can be traded in the open market (VIX) and indirectly by using derivatives
Volatility has some major problems
If returns were normal, mean and volatility would fully characterize risk, but
returns are non-normal, and in particular, have fatter tails.
Lehman Brothers, Long-Term Capital Holdings, the not-so-long-term firm in which
Scholes and Merton worked, Black Monday
Indifferent between loss and gain

Risk measures - Volatility
Risk Measures JP Morgans VaR
As we are familiar from class, one possible definition of VaR is:

Where L is the loss distribution and q is the quantile function and alpha
is one minus the probability of loss (authors call it confidence level)
Accounts only for downside
Included in Basel II
May favor concentration
Lower-bound estimate of the loss: VaR is not a measure of extreme risk

VaR (L) q
o
=
Example 1: VaR concentration
Imagine a bank has \$1M to invest.
In their investment set, they have two bonds, get 10% interest rate
99.3% of the time, lose everything 0.7% of the time.
If a financial institution holds one of the bonds, VaR 99% is zero
If they put half of their money in each bond, their VaR 99% is a little
less than \$500k.
Therefore, a bank with these investment opportunities might not
diversify when held to VaR targets.
Jn Danelson would probably rightfully argue that this example is too
hand-crafted.
Shortfall: a true measure of extreme risk
Expected loss given that the VaR has been breached

Always encourages diversification
[ | VaR] ES E L L = >
Example 2: Short Position in Call
Options
How to print money:
Imagine a portfolio like one (N) shares of an ETF and, for
concreteness, imagine its for the MSCI US Broad Market, and that its
spot price is \$60. Average daily return is close to zero, and its very
unlikely to be something like 6.6%. In order to enhance returns, we
sell a out-of-the-money call at \$64 with one day to expiration.
Maybe sell several options! Free money!
Not so fast: theres unlimited downside if the ETFs price goes over
\$64 and if you sell more than one option.
Note that you can also lose money if the ETF price falls.
Example 2: Shortfall vs. VaR
Example 2 illustrates
another problem with the
VaR: its a lower bound on
the probability of
happening.
Expected shortfall would
have captured that
problem.
Risk Analysis
Marginal Contribution to Risk
RC MCR
m m m
x
E E
=
Any risk measure that is homogeneous of degree 1 (scale invariant) can be
decomposed using Eulers theorem:
p
p m
m
m
x
x
cE
E =

## We can define risk contribution as:

risk exp re : osu
m
x
: (marginal contribution M CR to risk)
p
m
m
x
E
cE
Lets start by thinking about volatility. From the class slides:
p p
p m p m p m m
m
m m
x x x MCR
x x
o
o
o o
cE c
E = = =

, p m m m p
x o o =

The stand-alone volatility and the correlation of the asset with the portfolio
contribute to the portfolios risk. Thinking in this way may help manage the
portfolio risk.
p p
p m p m p m m
m
m m
x x x MCR
x x
o
o
o o
cE c
E = = =

, p m m m p
x o o =

The stand-alone volatility and the correlation of the asset with the portfolio
contribute to the portfolios risk. Thinking in this way may help manage the
portfolio risk.
Generalizing X-Sigma-Rho Risk
p m m
m
x MCR
E
E =

MCR
m m m

E E
= E
p m m m
m
x
E
E = E

## Generalizing X-Sigma-Rho Risk

1
MCR
m m
m
ES ES
ES
=
[ | VaR]
| VaR] [
m
m
E
P P
S P
E
E L L
L L

>
=
>
[ | VaR]
1
| VaR [ ]
m P
m
P
ES
P
E L L
E L L

>
s s
>
1 1
if L is symmetric
m
ES
s s
The marginal contribution to risk can do a
lot!
Example 3: Portfolio Insurance
ETF on the MSCI
price \$60
Put option to insure
against large losses,
strike \$50
Volatility gives a very
different picture of
risk than ES
Example 3: Portfolio Insurance