Chapter 10
Portfolio Risk Analytics and Reporting
Managing risk requires actually making decisions to increase, decrease, or alter the profile of risk. Making such decisions requires knowing not just the level of risk (the dispersion of the P&L distribution) but also the sources of risk in the portfolio and how changes in positions are likely to alter the portfolio risk. Risk measurement, to support this, must not only measure the dispersion of P&L (the primary focus for Chapters 8 and 9), but also the sources of risk. Litterman (1996, 59) expresses this well:
Volatility and VaR characterize, in slightly different ways, the degree of dispersion in the distribution of gains and losses, and therefore are useful for monitoring risk. They do not, however, provide much guidance for risk management. To manage risk, you have to understand what the sources of risk are in the portfolio and what trades will provide effective ways to reduce risk. Thus, risk management requires additional analysis—in particular, a decomposition of risk, an ability to find potential hedges, and an ability to find simple representations for complex positions.
In this sense, risk management merges into portfolio management. The present chapter discusses some of the tools and techniques suitable for such portfolio risk analysis. I particularly focus on:
Volatility and triangle addition as an aid for understanding ...
