Hello everyone, May someone kindly please explain the 3rd step of the Risk Budgeting process found in the core reading; -Performing VaR calculations to determine the total risk budget. How does one actually go about using VAR to determine the total risk budget and in what metric will the risk budget be? I'm a bit confused as to how the calculations in VAR can help with actually determining the Risk Budget.I'm failing to see the link. Thanks.
Hi, The risk budgeting process would be complex in reality, rather than the simple steps that are in the course notes, and every consultancy would have their own process. The key for step 2 is to get an idea of the total amount of risk that the client is able and willing to accept. This may be done by running various portfolios through the ALM, and working out the VaR, then assessing whether the client is happy to accept that VaR risk. So if you ask the client "are you happy with this sort of portfolio where there is a 1% chance over the coming 5 years that your fund will be underfunded to the tune of £3m?" and the client says "no", then you have used VaR to establish a level of total risk that is too high. The process would continue until the client is happy with a level of risk of loss that is presented by the model. the third step then begins, which is allocating that between the various types of risk.
