Advantages Of Risk Metrics

Given the risk considerations provided in the RCD tool and the Portfolio Theory, the next step should be understanding the available risk/return metrics and determining an optimal mix of assets.

Risk Metrics and Advantage/Disadvantages

There are two risk metrics used in the model, Conditional Tail Expectation (CTE) and Value at Risk (VaR). These two metrics both look at the tail of the distribution.

VaR is a measure of particularly poor outcomes in a stochastic projection. Its major shortcoming is its lack of statistical coherency. That being said, it does not satisfy a common risk principle that the aggregation of two risks should be less risky than each risk taken separately. The advantage of VaR is to measure risk over a very short

As mentioned by Ingram, CTE is generally considered “coherent”. He argues that it is most often used to measure risk over multi-year time frames that are needed to view risk. With the computing power in modern technologies, the capability to measure long-term risk makes CTE a more desirable metrics in risk management. The CTE metric reflect the outcomes in tail events, so that one can understand the impact when such events occur. Its primary benefit over the VaR metric is that it considers the complete distribution of scenarios that can occur within the tail.

The disadvantage of using CTE is that the metric can potentially hide specific outliers when averaging the tail experience. However, it is still a preferred to use the CTE as the primary risk metric for the CDEF management.

Risk/Return

This asset mix has a mean cost per employed person of 794. The CTE(90) is 879 which is within the “10% deviation from mean” boundaries the proposed requirement set.

In the event of adverse market, we need to put more conservatism into our consideration. It is expected that more outcomes will occur close to the worst scenarios we have tested. Therefore, for the adverse market, we should choose CTE(95) as we weighted more heavily on the 5% worst scenarios. As a result, an asset mix of 30/60/10 would produce the lowest CTE(95) within 10% difference to mean.

In the event of optimistic market, since the outcome is favorable and the worst-case scenario is unlikely, a CTE(75) could be a sufficient asset mix. In fact, at CTE(75), an asset mix of 0/70/20 offers the lowest CTE and highest return as a result of higher expected return from equities.

In Conclusion, the optimal asset class for Treasuries/Bonds/Equities could be attained at 15/70/15 splits. A recommended sample for investment policy and its requirement is summarized in below