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ACCA Strategic Professional · Strategic Business Leader · Identification, assessment and measurement of risk

Kallis Energy's board wants to estimate the maximum loss on its commodity portfolio that would not be exceeded on 99% of days over a one-day horizon, under normal market conditions. Which measure should the risk committee use, and what is its key limitation?

Value at risk is the appropriate measure because it states the loss not expected to be exceeded at a chosen confidence level and time horizon. Its key limitation is that it gives no information about how large losses could be beyond that threshold, in the extreme tail.

  1. AValue at risk; it gives no indication of the size of losses beyond the confidence thresholdCorrect
  2. BSensitivity analysis; it assigns probabilities to each possible outcome
  3. CExpected value; it shows the worst-case loss in the tail
  4. DScenario planning; it produces a statistical confidence level from historical data

Explanation

Value at risk states a loss level not expected to be exceeded at a given confidence over a given period. Its main weakness is that it says nothing about how severe losses may be in the remaining 1% tail, and it assumes normal market conditions. Expected value gives an average, not a worst case.

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