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