Quantitative Risk Management: A Practical Guide to Financial Risk, + Website

10.6 Risk Reporting

Effective, intelligent, and useful risk reporting is as important as the underlying analysis. Human intuition is not well adapted to recognize and manage randomness. Risks combine within a portfolio in a nonlinear and often highly nonintuitive manner. Even for the simplest case of normal distributions, the volatility (standard deviation) and VaR do not add so that the volatility or VaR of a portfolio is less than the sum of the constituents—this is diversification. Various tools, techniques, and tricks need to be used to elucidate the risk for even relatively standard portfolios.

To illustrate and explain the techniques for analyzing portfolio risk, I focus on a small portfolio with diverse positions and risks, and on a sample risk report that includes the marginal contribution, best hedges, and so on. The intention is not only to explain what the measures are and how to calculate them, but also to provide insight into how to use them and why they are valuable.

Risk Reporting—Bottom Up versus Top Down

The risk reports discussed here and the analytics behind them are based on a detailed view of the portfolio, aggregated up to a top level for summary purposes. This is a bottom-up process. Alternatively one could view risk reporting as a top-down process, the idea being that senior managers need a big-picture overview of firm-wide risk, and do not need to be concerned with details of individual desks or units. A top-down approach is often driven by the number and ...