Risk Measurement and Analytics Flashcards

What is the difference between 'expected loss' and 'unexpected loss' in risk management?

Answer: Expected loss is the average anticipated loss priced into products; unexpected loss requires capital as a buffer

Expected loss is the average loss built into pricing and provisions; unexpected loss is the deviation above expected that economic capital is designed to absorb.

Backtesting a VaR model involves:

Answer: Comparing VaR forecasts against actual trading P&L to assess model accuracy

Backtesting compares the VaR estimate with actual daily P&L outcomes to assess whether exceptions (losses exceeding VaR) occur at the modeled frequency.

In risk management, what is the concept of 'fat tails' (leptokurtosis)?

Answer: A distribution where extreme losses occur more frequently than predicted by a normal distribution

Fat tails describe return distributions with excess kurtosis where extreme events occur more often than a normal distribution would predict, understating risk if normality is assumed.

What is economic capital in the context of financial risk management?

Answer: The capital a firm estimates it needs to absorb unexpected losses at a specified confidence level

Economic capital is internally calculated based on the firm's own risk models to absorb unexpected losses at a high confidence level (e.g., 99.9%), independent of regulatory minima.

Which measure captures how much a single position contributes to overall portfolio VaR?

Answer: Component VaR

Component VaR allocates total portfolio VaR to individual positions, showing each position's contribution including diversification effects.

The 'correlation coefficient' in portfolio risk is important because:

Answer: It measures the degree to which two asset returns move together, affecting portfolio diversification

Portfolio variance and diversification benefits depend heavily on the correlation between asset returns; lower correlations yield greater risk reduction.