IDEAS home Printed from https://ideas.repec.org/a/cpn/umkcjf/v5y2016i2p85-108.html
   My bibliography  Save this article

Risky Risk Measures: A Note On Underestimating Financial Risk Under The Normal Assumption

Author

Listed:
  • Christiane Goodfellow
  • Christian Salm

    (Jade University
    Jade University)

Abstract

This note compares three different risk measures based on the same stock return data: (1) the portfolio variance as in Markowitz (1952), (2) the value at risk based on the historical return distribution, and (3) the value at risk based on a t copula. Unless return series follow a Normal distribution, Normal-based risk measures underestimate risk, particularly so during periods of market stress, when accurate risk measurement is essential. Based on these insights, we recommend that supervisors discontinue to accept Normal-based value at risk estimations. We are happy to share our commented R-code with practitioners who wish to implement our methodology. Risk measurement is the foundation of risk management and hence of vital importance in any financial institution. Supervisory capital requirements according to Basel III or Solvency II are also derived from risk measures. Investors are interested in ratings which are based on risk assessments. This note is therefore relevant to practitioners and supervisors alike.

Suggested Citation

  • Christiane Goodfellow & Christian Salm, 2016. "Risky Risk Measures: A Note On Underestimating Financial Risk Under The Normal Assumption," Copernican Journal of Finance & Accounting, Uniwersytet Mikolaja Kopernika, vol. 5(2), pages 85-108.
    • Handle: RePEc:cpn:umkcjf:v:5:y:2016:i:2:p:85-108
    as

    Download full text from publisher

    File URL: https://apcz.umk.pl/CJFA/article/view/CJFA.2016.017/11420
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Campbell, Rachel & Huisman, Ronald & Koedijk, Kees, 2001. "Optimal portfolio selection in a Value-at-Risk framework," Journal of Banking & Finance, Elsevier, vol. 25(9), pages 1789-1804, September.
    2. Mark Rubinstein, 2002. "Markowitz's “Portfolio Selection”: A Fifty‐Year Retrospective," Journal of Finance, American Finance Association, vol. 57(3), pages 1041-1045, June.
    3. Burton G. Malkiel, 2003. "Passive Investment Strategies and Efficient Markets," European Financial Management, European Financial Management Association, vol. 9(1), pages 1-10, March.
    4. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, March.
    5. Benoit Mandelbrot, 2015. "The Variation of Certain Speculative Prices," World Scientific Book Chapters, in: Anastasios G Malliaris & William T Ziemba (ed.), THE WORLD SCIENTIFIC HANDBOOK OF FUTURES MARKETS, chapter 3, pages 39-78, World Scientific Publishing Co. Pte. Ltd..
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Eyden Samunderu & Yvonne T. Murahwa, 2021. "Return Based Risk Measures for Non-Normally Distributed Returns: An Alternative Modelling Approach," JRFM, MDPI, vol. 14(11), pages 1-48, November.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Allen, David & Lizieri, Colin & Satchell, Stephen, 2020. "A comparison of non-Gaussian VaR estimation and portfolio construction techniques," Journal of Empirical Finance, Elsevier, vol. 58(C), pages 356-368.
    2. Jovanovic, Franck & Schinckus, Christophe, 2017. "Econophysics and Financial Economics: An Emerging Dialogue," OUP Catalogue, Oxford University Press, number 9780190205034.
    3. K. Saranya & P. Prasanna, 2014. "Portfolio Selection and Optimization with Higher Moments: Evidence from the Indian Stock Market," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 21(2), pages 133-149, May.
    4. Dominique Guégan & Wayne Tarrant, 2012. "On the necessity of five risk measures," Annals of Finance, Springer, vol. 8(4), pages 533-552, November.
    5. Allan, Grant & Eromenko, Igor & McGregor, Peter & Swales, Kim, 2011. "The regional electricity generation mix in Scotland: A portfolio selection approach incorporating marine technologies," Energy Policy, Elsevier, vol. 39(1), pages 6-22, January.
    6. Bao, Te & Diks, Cees & Li, Hao, 2018. "A generalized CAPM model with asymmetric power distributed errors with an application to portfolio construction," Economic Modelling, Elsevier, vol. 68(C), pages 611-621.
    7. Sun, Xiaolei & Li, Jianping & Tang, Ling & Wu, Dengsheng, 2012. "Identifying the risk-return tradeoff and exploring the dynamic risk exposure of country portfolio of the FSU's oil economies," Economic Modelling, Elsevier, vol. 29(6), pages 2494-2503.
    8. Luca Riccetti, 2013. "A copula–GARCH model for macro asset allocation of a portfolio with commodities," Empirical Economics, Springer, vol. 44(3), pages 1315-1336, June.
    9. Mario Alejandro Acosta R., 2014. "Las acciones como activo de reserva para el Banco de la República," Documentos CEDE 11004, Universidad de los Andes, Facultad de Economía, CEDE.
    10. Douglas J. Hodgson & Oliver Linton & Keith Vorkink, 2002. "Testing the capital asset pricing model efficiently under elliptical symmetry: a semiparametric approach," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 17(6), pages 617-639, December.
    11. He, Xue-Zhong & Li, Youwei, 2015. "Testing of a market fraction model and power-law behaviour in the DAX 30," Journal of Empirical Finance, Elsevier, vol. 31(C), pages 1-17.
    12. Lassance, Nathan & Vrins, Frédéric, 2021. "Portfolio selection with parsimonious higher comoments estimation," Journal of Banking & Finance, Elsevier, vol. 126(C).
    13. Jules Sadefo-Kamdem, 2011. "Downside Risk And Kappa Index Of Non-Gaussian Portfolio With Lpm," Working Papers hal-00733043, HAL.
    14. Rui Pedro Brito & Hélder Sebastião & Pedro Godinho, 2016. "Efficient skewness/semivariance portfolios," Journal of Asset Management, Palgrave Macmillan, vol. 17(5), pages 331-346, September.
    15. Gourieroux, C. & Monfort, A., 2005. "The econometrics of efficient portfolios," Journal of Empirical Finance, Elsevier, vol. 12(1), pages 1-41, January.
    16. Wilford, D. Sykes, 2012. "True Markowitz or assumptions we break and why it matters," Review of Financial Economics, Elsevier, vol. 21(3), pages 93-101.
    17. Kerstens, Kristiaan & Mounir, Amine & Van de Woestyne, Ignace, 2011. "Geometric representation of the mean-variance-skewness portfolio frontier based upon the shortage function," European Journal of Operational Research, Elsevier, vol. 210(1), pages 81-94, April.
    18. Jochen Güntner & Benjamin Karner, 2020. "Hedging with commodity futures and the end of normal Backwardation," Economics working papers 2020-21, Department of Economics, Johannes Kepler University Linz, Austria.
    19. Anand, Abhinav & Li, Tiantian & Kurosaki, Tetsuo & Kim, Young Shin, 2016. "Foster–Hart optimal portfolios," Journal of Banking & Finance, Elsevier, vol. 68(C), pages 117-130.
    20. Ibragimov, Rustam & Walden, Johan, 2007. "The limits of diversification when losses may be large," Scholarly Articles 2624460, Harvard University Department of Economics.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:cpn:umkcjf:v:5:y:2016:i:2:p:85-108. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Miroslawa Buczynska (email available below). General contact details of provider: http://www.wydawnictwoumk.pl .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.