Risk Metrics Calculations: Exposure Calculating

Risk Metrics Calculations: Exposure

Calculating credit exposure ha always been an issue of importance when evaluating a portfolio or particular company for potential risks, yet recently the issue has gained increasing prominence and importance in the world of finance. Since the events of 2008, when a cascade of failures was triggered as the result of unidentified exposure risks, analysts have reexamined the means by which exposure is calculated and the general manner in which exposure is viewed (Argentin 2010). Given the increasing interconnectedness and complexities of most businesses operating today, repercussions of a single company's failure can be quite far-reaching and profound; if company A fails while owing payments for trade to company B, company B's creditors and clients might also be affected by this disruption of company B's cash flow and increased risk due to its exposure in company A (Argentin 2010).

Developing an adequate calculation for a give company or portfolio's true exposure given the inverse risk that occurs in trade situations is more complex than previously thought, therefore (Argentin 2010). Still, the covariance model that forms one of the triumvirate of models utilized by risk metrics can be used to develop and calculations concerning a company or portfolio's exposure even with the added complexities of these inverse risk relationships. Tools provided by RiskMetrics allow for the fine0tuned defining of an Expected Negative Exposure variable similar to the Expected Positive Exposure variable, both of which can be incorporated into the Credit Exposure framework that accounts for valuations, trade balances, and timelines specific to the user's needs (Argentin 2010). These added tools make the calculation of exposure through RiskMetric's Credit Exposure framework far more accurate if slightly more complex, which comes as a welcome trade-off for the increased performance of the calculation tools to almost any investor or portfolio/fund manager.

RiskMetrics Calculations: Uncertainty

Risk in all of its forms is directly and wholly a result of uncertainty, by its very definition: risk is the potential that assets might be lost or harm might occur due to a variety of known forces moving in unknown directions, with the potential for unknown forces to influence outcomes as well. Classifying "uncertainty" as a specific area of risk, then, might seem at once somewhat redundant and nearly impossible -- all risk is uncertainty, and all uncertainty creates risk (Finger 2007). There are, however, certain parameters of risk and uncertainty that can be singled out as especially necessary when calculating the overall risk facing investment in a given company or the potential uncertainties of an entire portfolio. Uncertainties in market conditions and performance are typically dealt with in the creation of the overall model used to for risk analysis and are the basic items analyzed in measured in specific risk calculations; measuring the whole of the uncertainties in a given portfolio with the use of a specific model is measuring risk according to that model, directly and simply, and requires an abundance of model-specific calculations (Finger 2007).

Part of the overall calculation of uncertainty according to RiskMetrics recommendations, however, should include a calculation of correlative uncertainty (Finger 2007). The rationale for including this specific uncertainty in calculations is that it helps to account for inaccuracies and inadequacies in the model, determining the level of risk associated with incorrectly defined or changing correlations used by the model in other calculations and definitions (Finger 2007). An accurate calculation of uncertainty and risk will necessarily include a calculation of the correlative uncertainties attendant upon the model and the situation to which it is applied, providing not a necessarily more accurate view of direct risk, but a useful evaluation of the risk prediction's efficacy.

RiskMetrics Calculations: Exposure and Uncertainty