The Mismeasurement of Risk

Peter Gallo SMF, University of Connecticut 2/12/2008

Source: Kritzman, Mark & Rich, Don, The Mismeasurement of Risk , Working Paper

Copyright: UConn Student Managed Fund, 2008

Agenda
1. 2. 3. 4.

Summary of Equations Within Horizon Probability of Loss Value at Risk Continuous Within Horizon Probability of Loss

5. 6.

Possible Uses Implementation (SMF)

Copyright: UConn Student Managed Fund, 2008

Summary of the Equations

Currently, many investors measure risk at the end of an investment period
Maximum allowable loss Desired Return

Do not measure risk or accuracy of financial agent during the investment period
2 Equations

Copyright: UConn Student Managed Fund, 2008

Within Horizon Probability of Loss

End of Horizon Calculation

N is the Cum. Normal Distribution Function L is the Cum. Percentage Loss in Periodic Units Mu is the Annualized Expected Return in Continuous Units T is the Number of years in the horizon Sigma is the Annualized Standard Deviation of Continuous Returns

Uses
Source: Kritzman, Mark & Rich, Don, The Mismeasurement of Risk , Working Paper
Copyright: UConn Student Managed Fund, 2008

Value At Risk
End of Horizon Calculation

E is the Base of Natural Log (2.71828) Z is the Normal Deviate associated with the chosen probability W is Initial Wealth

Uses

Source: Kritzman, Mark & Rich, Don, The Mismeasurement of Risk , Working Paper
Copyright: UConn Student Managed Fund, 2008

End of Time Horizon

Continuous

This principle simple states that for continuous monitoring of an investment through a time period where the expected return is zero, the investments return path can just as likely be its mirror opposite whether positive or negative

Continuous Within-Horizon Probability of Loss

Continuous Calculation

Uses

Source: Kritzman, Mark & Rich, Don, The Mismeasurement of Risk , Working Paper
Copyright: UConn Student Managed Fund, 2008

Possible Uses
1. Asset Manager Portfolio Percentage Decrease 2. Hedge Fund Manager Leverage Losses 3. Loan Manager Call Loans As the time horizon increases, within horizon probability of a loss increases where the end of period diminishes due to the number of dates/times and the overall risk. However, while the end of period risk decreases with time, it is offset by the possible magnitude of a the loss Samuelson, 1963

Copyright: UConn Student Managed Fund, 2008

Implementation SMF

Monitored Roughly through Yahoo! Finance Accounts Practical for Managing Asset Managers Practical for SMF? Thanks, wink

Copyright: UConn Student Managed Fund, 2008