LO 38.4: Describe the role of and issues with correlation in risk aggregation, and describe typical properties of a firms market risk, credit risk, and operational risk distributions.
Firms that use value at risk (VaR) to assess potential loss amounts will ultimately have three different VaR measures to manage. Market risk, credit risk, and operational risk will each produce their own VaR measures. The trick to accurately measuring and managing firm wide risk, and in turn firm-wide VaR, is to understand how these VaR measures interact. Market risks will typically follow a normal distribution; however, the distributions for credit risks and operational risks are usually asymmetric in shape, due to the fat-tail nature of these risks.
Due to diversification effects of aggregating market, credit, and operational risk, firm-wide VaR will be less than the sum of the VaRs from each risk category. This suggests that the correlation among risks is some value less than one. It can be difficult to determine this correlation amount, so firms typically use average correlation values within their respective industry. However, firms should recognize that correlations can be influenced by firm- specific actions as well as external events such as a financial crisis.
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Topic 38 Cross Reference to GARP Assigned Reading – Nocco & Stulz
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