Jorion's Definition of "Financial Risk"

[superpocoyo]

Hi David,

Q&A P1.T1.1. What is Risk on page 27, "Note: an arguable weakness of Jorion's definition is that volatility includes upside movements. But risk is generally only concerned with "left-tail" losses; e.g. VAR is always one-tailed (VaR is always 1.645 normal deviates at 95% confidence and VaR is never 1.96 normal deviates at 95%)".

Does this statement indicate that "financial risk" actually should include the upside movements of the "volatility" as well? Hence, choice d) should be wrong? I think d) is wrong because "financial risk" should consist of "expected loss" as well as "unexpected loss". Why risk include the upside movement as well? VaR right-tail should be profit, not risk.

Thanks

Melody

 

[David Harper CFA FRM]

Hi Melody,

Great points! (+1 star for nice contribution). When the FRM replaced Jorion Chapter 1 with the IFC, I think they undermined the introduction to the syllabus. Among other things, T1 lost Jorion's definition of risk to the following in the (currently assigned) IFC

“Risk is a concept linked to human expectations. It indicates a potential negative effect on an asset that may derive from given processes in progress or given future events. In the common language, risk is often used as a synonym of probability of a loss or of a danger. In the assessment of professional risk, the concept of risk combines the probability of an event occurring with the impact that event may have and with its various circumstances of happening.”

But this is not very specific (and operationally open to interpretation, I think). It's not terrible because, in a certain sense, the FRM is about the idea that risk has several dimensions, modes [market, credit, ...] and various mathematical implementations. In a way, there is not one conclusive definition.

Okay, but P1.T1.1 (What is risk) is just querying Jorion's definition of risk (and Jorion of course is very authoritative, while the assignment has been dropped, Jorion still has more authority than the IFC authors, IMO): (Financial) risk is the volatility of unexpected outcomes.
... where two "virtues" of this definition include

1. A reference to unexpected outcomes; we are not obligated to include "expected losses" (or expected outcomes) in risk. For example, capital for credit risk in Basel generally excludes expected losses. Bonds are priced for expected losses: if they default exactly as we expect, it's hard to argue that's a risk per se. In this way (d) Expected loss [by itself![ is clearly false. It's really just UL. In practice, when capital is used to cover it, sometimes we are implicitly defining risk as EL+UL, so it's not a big "violation" to do so, but it's really UL (The issue is that EL remains a prediction so EL itself has variability, and for this reason, I think including EL can be justified in many cases. But we don't want to use EL and not UL).
   
2. The definition is broader than price movement, as noted.

My note ("Note: an arguable weakness of Jorion’s definition is that volatility includes upside movements ...) is just my personal append to reference the controversy of using a measure (volatility) that is technically indifferent to unexpected upside versus unexpected downside. In using "volatility" Jorion is helpfully using the most common metric, but I just wanted to note the well-known problem. This relates to the motive for downside deviation and Sortino measures, which overcome this flaw but, on the other hand, are clearly much less popular. I hope that explains!

 

[superpocoyo]

Hi David,

Thanks very much for your explanation. It makes sense to me now.

Melody