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

9.3 Summary Measures to Standardize and Aggregate

Summary risk measures are used, primarily, in two related but conceptually distinct ways:

1. To standardize, aggregate, and analyze risk across disparate assets (or securities, trades, portfolios) under standard or usual trading conditions.

2. To measure tail risk or extreme events.

In this section, we discuss using volatility (or VaR) to standardize and aggregate. We turn to tail events in the next section.

Standardize under Normal Trading Conditions

Using volatility and VaR as tools for comparing across disparate assets under standard or normal trading conditions is relatively straightforward. To understand this use better, consider our simple portfolio, and say that a bond trader with experience in the U.S. government bond market is promoted to manage our hypothetical portfolio, which includes both U.S. Treasuries and French equities. From long experience in the bond market, the trader knows intuitively what the risk is of $20M in 10-year U.S. Treasuries (or any other U.S. bond, for that matter). Were this trader to manage only U.S. Treasuries, he would know from long experience how much particular trades might make or lose during a normal trading period, how trades would interact together in a portfolio, and have a good idea of how positions might behave during extreme conditions. But the trader has little experience with equities, does not have the same depth of experience and intuition, and needs some way to compare equity ...