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Expected Shortfall

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Expected Shortfall

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bphoa138
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© © All Rights Reserved
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Deviations from Normality and Risk Measures

Deviations from normality may be discerned by calculating the higher


moments of return distributions. The n th central moment of a
distribution of excess returns, R, is esti-mated as the average value of
( R−R )n. The first moment (n = 1) is necessarily zero (the average
deviation from the sample average must be zero). The second moment
( n= 2) is the estimate of the variance of returns, σ 2 .

A measure of asymmetry called skew uses the ratio of the average cubed
deviations from the average, called the third moment, to the cubed
standard deviation to measure asymmetry or “skewness” of a

[ ]
3
(R−R)
distribution. Skew = Average
σ3

Cubing deviations maintains their sign (the cube of a negative number is


negative). When a distribution is “skewed to the right,” as is the dark
curve in Figure 5.5A, the extreme positive values, when cubed, dominate
the thirdmoment, resulting in a positive skew. When adistribution is
“skewed to the left,” the cubed extreme negative values dominate, and
the skew will be negative.

Another potentially important deviation from normality, kurtosis,


concerns the likelihood of extreme values on either side of the mean at
the expense of a smaller likelihood of moderate deviations. Graphically
speaking, when the tails of a distribution are “fat,” there is more
probability mass in the tails of the distribution than predicted by the
normal distribution, at the expense of “slender shoulders,” that is, less
probability mass near the center of the distribution. Figure 5.5B
superimposes a “fat-tailed” distribution on a normal with the same
mean and SD. Although symmetry is still preserved, the SD will
underestimate the likelihood of extreme events: large losses as well as
large gains.
Kurtosis measures the degree of fat tails. We use deviations from the
average raised to the fourth power, scaled by the fourth power of the
SD. Kurtosis=Average¿
Value at Risk
The value at risk (denoted VaR to distinguish it from Var, the
abbreviation for variance) is the loss corresponding to a very low
percentile of the entire return distribution, for example, the 5th or 1 st
percentile return. VaR is actually written into regulation of banks and
closely watched by risk managers. It is another name for quantile of a
distribution.
When portfolio returns are normally distributed, the VaR is determined
by the mean and SD of the distribution. Recalling that - 1.65 is the 5th
percentile of the standard normal distribution (with mean = 0 and SD =
1), the VaR for a normal distribution is
VaR(.05, normal) = Mean – 1.65 SD
To obtain a sample estimate of VaR, we sort the observations from high
to low. The VaR is the return at the 5th percentile of the sample
distribution. Almost always, 5% of the number of observations will not
be an integer, and so we must interpolate. Suppose a sample comprises
84 annual returns so that 5% of the number of observations is 4.2. We
must interpolate between the fourth and fifth observation from the
bottom. Suppose the bottom five returns are
- 25.03% - 25.69% - 33.49% - 41.03% - 45.64%
The VaR is therefore between 2 25.03% and 2 25.69% and would be
calculated as

VaR = - 25.69 + 0.2(25.69 - 25.03) = - 25.56%


Expected Shortfall

Expected Shortfall (ES), also known as Conditional Value at Risk (CVaR),


is a risk measure that goes beyond Value at Risk (VaR). While VaR
provides an estimate of the maximum loss within a certain confidence
level, ES quantifies the average loss given that the loss exceeds the VaR.

In other words, ES measures the expected value of losses that occur


beyond the VaR threshold. It provides a more comprehensive
assessment of the tail risk and the potential magnitude of losses in
extreme market conditions. Financial institutions often use ES to gain
insights into the potential impact of extreme events on their portfolios.

Lower Partial Standard Deviation and the Sortino Ratio

Lower Partial Standard Deviation (LPSD) and the Sortino Ratio are both
risk measures that focus on downside risk in financial analysis.

Lower Partial Standard Deviation (LPSD):


LPSD is a measure of volatility that considers only the periods when
returns are below a certain threshold (the minimum acceptable return).
It provides insight into the risk associated with negative deviations from
the expected return.

For: Xi<μ
Notice that the mean value, μ, is computed using Equation (4). In other
words, you need to use your entire sample of n observations to compute
the mean value but consider only negative deviations from the mean in
computing the LPSD.
Sortino Ratio:

The Sortino Ratio is a risk-adjusted performance measure that takes into


account only the downside risk.
It is calculated by dividing the excess of the expected return over a risk-
free rate by the downside deviation, which is the standard deviation of
negative returns.
The Sortino Ratio is useful for investors who are particularly concerned
about the potential for losses.
Both LPSD and the Sortino Ratio aim to provide a more targeted view of
risk, especially focusing on negative outcomes, compared to more
general measures like standard deviation or Sharpe ratio.

Relative Frequency of Large, Negative 3-Sigma Retu

The relative frequency of large, negative 3-Sigma returns refers to the


proportion of occurrences where the return is more than three standard
deviations below the mean in a financial dataset. This is often used in
statistical analysis to assess the likelihood of extreme negative events.
By calculating the relative frequency of such events, investors and
analysts can gain insights into the occurrence of severe downturns or
outliers beyond the normal expected range. A higher relative frequency
of large, negative 3-Sigma returns may suggest a higher level of
downside risk and potential for significant losses in the financial data
being analyzed.

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