The purpose of having accurate risk measurement tools is to benefit traders and investors. In this chapter, we tie together the modeling tools we have developed and see how to move from risk measurement to risk management. Ultimately, the benefits of risk measurement come from putting investors in a better position to make tradeoffs between risk and return, and between different aspects of risk. Some investors may be more tolerant of volatility, but quite sensitive to the risk of large losses. If adequately compensated, other investors may prefer exposure to large losses, but remain averse to volatility, a risk profile characterizing some option portfolios and senior securitized credit products. Metaphorically, one can imagine investors chooseing distributions of returns they prefer over distributions that are inferior from their point of view. It is only a metaphor, in view of the problems in maintaining a distributional hypothesis on returns that we've encountered in earlier chapters. Among the risk management objectives market participants might have are:
Reduce volatility of portfolio returns, including any hedges.
Diversification. Risk measurement tools can be used to ensure the portfolio does not contain any undesired concentrations and to identify exposures to extreme economic scenarios.
Left-tail truncation. Identifying extreme-loss scenarios and the positions that contribute to them can guide investors to reducing the extreme losses ...