Contrasting broadly adopted model-based portfolio risk measures with current market conditions

Abstract

The last two years have seen the most volatile financial markets for decades with steep losses in asset values and a deteriorating world economy. The insolvency of several banks and their negative impact on the economy has led to criticism of their risk management systems for not being adequate and lacking foresight. This thesis will study the performance of two broadly adopted portfolio risk measures before and during the current financial turbulence to examine their accuracy and reliability. The study will be carried out on a case portfolio consisting of American and European fixed income and equity. The portfolio uses a dynamic asset allocation scheme to maximize the ratio between expected return and portfolio risk. The market risk of the portfolio will be calculated on a daily basis using both Value-at-Risk (VaR) and expected shortfall (ES) in a Monte Carlo framework. These risk measures are then compared with prior measurements and the actual loss over the period. The results from the study indicate that the implemented risk model do not give totally reliable estimates, with more frequent and larger real losses than predicted. Nevertheless, the study sees a significant worsening in the performance of the risk measures during the current financial crisis from June 2007 to December 2008 compared with the previous years. This thesis argues that VaR and ES are useful risk measures, but that users should be well aware of the pitfalls in the underlying models and take appropriate precautions.