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The Long View of Financial Risk

Journal of Investment Management (JOIM), First Quarter 2010

Posted: 13 Mar 2010 Last revised: 3 Jun 2010

Lisa R. Goldberg

University of California, Berkeley; Aperio Group

Michael Y. Hayes

MSCI Inc.

Multiple version iconThere are 2 versions of this paper

Date Written: March 11, 2010

Abstract

We discuss a practical and effective extension of portfolio risk management and construction best practices to account for extreme events. The central element of the extension is (expected) shortfall, which is the expected loss given that a value-at-risk limit is breached. Shortfall is the most basic measure of extreme risk, and unlike volatility and value at risk, it probes the tails of portfolio return and profit/loss distributions. Consequently, shortfall is (in principle) a guide to allocating reserve capital. Since it is a convex measure, shortfall can (again, in principle) be used as an optimization constraint either alone or in combination with volatility. “In principle” becomes “in practice” only if shortfall can be forecast accurately. A recent body of research uses factor models to generate robust, empirically accurate shortfall forecasts that can be analyzed with standard risk management tools such as betas, risk budgets and factor correlations. An important insight is that a long history of returns to risk factors can inform short-horizon shortfall forecasts in a meaningful way.

Keywords: Shortfall, volatility, return horizon, convex risk measure, diversification, portfolio optimization, reverse optimization, marginal contribution to risk, risk-implied correlation, beta

JEL Classification: G00

Suggested Citation

Goldberg, Lisa R. and Hayes, Michael Y., The Long View of Financial Risk (March 11, 2010). Journal of Investment Management (JOIM), First Quarter 2010. Available at SSRN: https://ssrn.com/abstract=1568893

Lisa R. Goldberg (Contact Author)

University of California, Berkeley ( email )

Department of Statistics
367 Evans Hall
Berkeley, CA 94720-3860
United States

Aperio Group ( email )

3 Harbor Drive
Suite 315
Sausalito, CA 94965
United States

Michael Y. Hayes

MSCI Inc. ( email )

2100 Milvia St.
Berkeley, CA 94704
United States

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