Hi Did anyone else struggle to understand chp 12? I took some strain. One of my (many) questions is the following: On page 5 the RAPM formula is given - can someone please explain the numerator and the formula in more detail to me? It does not make 100% sense to me - RAPM measures the return (net of costs and expected losses) as a % of capital held to cover unexpected losses? Also I thought VAR is a measure of risk that measures "unexpected" loss - see top pg 5 and pg 6 paragraph under example and definition in box lower down on pg 6. However at the bottom of pg 5, last sentence "expected" losses is used? Thanks.
chapter 12 or 13? I think you are referring to chapter 13 here. It is a tricky chapter but I think your problems stem from being too attached to the concept of expected or unexpected. I know it does say this on pages 5 and 6, but my feel for this is that a general insurer (for example) will incur losses on some of its policies. Each one of these losses is to some extent an "unexpected" loss, but because they happen as part of the normal business, an average level of these losses could be described as "expected" losses for the company. These losses can make the resulting profit very volatile from year to year, and hence we can calculate a VaR. Since VaR looks at the extreme end of the distribution, which we would not expect to happen except in extreme situations, we can call these "unexpected" losses. But there is no problem in dividing the profit after expected losses, by an amount of capital (which is sufficient to cope with quite an extreme "unexpected" level of losses.
