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Conditional Value at Risk and Stress Testing in Financial Risk Management - YouTube
Channel: Patrick Boyle
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Hi my name is Patrick Boyle. Welcome back
to my YouTube channel where we're
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learning all about derivatives and
quantitative finance. If this is the
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first video you're watching, make sure
you click on the subscribe button to see
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more content like this.
I've just done a series of videos
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explaining what Value at Risk is and
this one is the last on that topic by
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the end of this video you'll understand
the expected shortfall and stress
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testing and how they're used by risk
managers. Expected shortfall which is
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also known as Conditional Value at Risk
or CVaR is related to VaR but is maybe
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a little bit more conservative. Expected
shortfall calculates the average of the
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losses in the worst X percent of cases
var might tell you that a loss of
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$1,000,000 or greater is a var 99% break
expected shortfall would then calculate
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the average return of all of those worst
1% of days the expected shortfall figure
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at a given confidence level will always
be a larger negative number than far at
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that confidence level in addition to
calculating var financial institutions
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will also carry out stress testing now
stress testing is a big part of risk
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management and most traders will build
their own stress test simply to
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understand the risks on their books and
kind of how bad things can get so what
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does stress testing involve well it
involves testing how a portfolio would
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have performed in extreme market
conditions now there's a few ways of
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doing this one would be just to describe
the stressful market conditions so we'll
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say for example if you looked at how
your portfolio would perform if the
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stock market fell by we'll say 10% and
the implied volatility tripled in a day
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that's one way of doing it you can come
up with all sorts of stressful scenarios
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to test how your portfolio performs in
them another approach is to look at
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actual real events and see how your
portfolio would have held up during
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those events so we'll say for example
events like the 1987 crash
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September 11 2001 or during the worst
days of the financial crisis of 2007
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2008 so that's what stress testing is
and then on top of that they're stressed
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var or S var which is a measure of
market risk tailored to stress market
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conditions this measure incorporates
scenario analysis in a standard var
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setting so in wrapping up this series of
videos on Value at Risk I'd like to
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point out that successful risk
management is very much in the details
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well there's a lot of useful formulas
out there to help the risk manager and
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we've gone through a lot of those in
their series the subjective component of
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risk management is significant a good
risk manager at a financial institution
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spends a lot of time out on the trading
floor talking to the traders and trying
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to understand what they do and how they
think about risk and what kind of risks
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they're willing to take and they're
unwilling to take and so once a risk
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manager understands the engine that
generates the firm's profits they'll be
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much more capable as a risk manager
rather than someone who just runs
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quantitative screens on a spreadsheet
and goes around the floor telling people
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that their var is too high that's often
not the most useful form of risk
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management a good risk manager is going
to understand the true risks at the firm
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or the portfolio is exposed to so a line
that always amused me is a well-known
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hedge fund manager David Einhorn has
compared var to an airbag that works all
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of the time except when you have a car
accident and there's a certain amount of
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truth to that you know as I explained in
my earlier videos about var it's telling
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you what a normal but there an average
bad day looks like but that doesn't
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necessarily inform you very much as to
how horrible things can get or how crazy
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the market can get now wild var does
have many flaws it does still add some
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value as a tool of risk management like
all of the formulas that we do use in
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quantitative finance
var does suffer from the garbage in
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garbage out problem and I've kind of
mentioned that probably in every video
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that I've done that explains a formula
in quantitative finance we do use a lot
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of formulas and when you're a beginner
they can seem super exciting because
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these formulas are often derived from
places like physics or engineering and
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to those who don't really know any
better they seem to give rock solid
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answers they'll tell you the perfect
price for a given option or the exact
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amount of risk on the books but in
finance
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unlike in physics or engineering most of
the inputs are predictions rough
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estimates or numbers so for a variety of
reasons can change very quickly so the
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formulas that we use help us to compare
value or help to give us a way of
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understanding the risk on the books
today compared to the risks on the books
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last month financial mathematics is
extremely useful and I've made a career
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in quantitative finance on by no means
knocking the usefulness of these
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formulas it's extremely useful to an
investor or a risk manager who always
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keeps in mind the assumptions that are
underlying the various formulas and
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someone who is aware of how these things
can go wrong so I've always argued a
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student of finance and risk management
needs to spend some time studying
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financial history in fact when I teach
my class on financial derivatives at
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King's College London I devote one whole
class to discussing examples of
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financial derivatives disasters and what
we can learn from them while every
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financial crisis is different important
lessons can be learned from the past all
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of these videos are based on my book
which is called trading and pricing
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financial derivatives which is available
on Amazon and there is a link below hit
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the like button to let me know if you
found this video helpful and hit the
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anyhow have a great day and see you next
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week bye
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you
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